Understanding the risk of synthetic CDOs
Synthetic collateralized debt obligations, or synthetic CDOs, are popular vehicles for trading the credit risk of a portfolio of assets. Following a brief summary of the development of the synthetic CDO market, I draw on recent innovations in modeling to present a pricing model for CDO tranches that does not require Monte Carlo simulation. I use the model to analyze the risk characteristics of the tranches of synthetic CDOs. The analysis shows that although the more junior CDO tranches -- equity and mezzanine tranches -- typically contain a small fraction of the notional amount of the CDO's reference portfolio, they bear a majority of the credit risk. One implication is that credit risk disclosures relying on notional amounts are especially inadequate for firms that invest in CDOs. I show how the equity and mezzanine tranches can be viewed as leveraged exposures to the underlying credit risk of the CDO's reference portfolio. Even though mezzanine tranches are typically rated investment-grade, the leverage they possess implies their risk (and expected return) can be many times that of an investment-grade corporate bond. The paper goes on to show how CDO tranches and other innovative credit products, such as single-tranche CDOs and first-to-default basket swaps, are sensitive to the correlation of defaults among the credits in the reference portfolio. Differences of opinion among market participants as to the correct default correlation can create trading opportunities. Finally, the paper shows how the dependence of CDO tranches on default correlation can also be characterized and measured as an exposure to the business cycle, or as "business cycle risk." A mezzanine tranche, in particular, is highly sensitive to business cycle risk.
|Date of creation:||2004|
|Contact details of provider:|| Postal: 20th Street and Constitution Avenue, NW, Washington, DC 20551|
Web page: http://www.federalreserve.gov/
More information through EDIRC
|Order Information:||Web: http://www.federalreserve.gov/pubs/feds/fedsorder.html|
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- S. Illeris & G. Akehurst, 2002. "Introduction," The Service Industries Journal, Taylor & Francis Journals, vol. 22(1), pages 1-3, January.
- Jeffery D Amato & Eli M Remolona, 2003. "The credit spread puzzle," BIS Quarterly Review, Bank for International Settlements, pages -, December.
When requesting a correction, please mention this item's handle: RePEc:fip:fedgfe:2004-36. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Franz Osorio)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.