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Do Rare Events Explain CDX Tranche Spreads?

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  • Sang Byung Seo
  • Jessica A. Wachter

Abstract

We investigate whether a model with a time-varying probability of economic disaster can explain the pricing of collateralized debt obligations, both prior to and during the 2008-2009 financial crisis. Namely, we examine the pricing of tranches on the CDX, an index of credit default swaps on large investment-grade firms. CDX senior tranches are essentially deep out-of-the money put options because they do not incur losses until a large fraction of previously stable firms default. As such, these products clearly reflect the market’s assessment of rare-event risk. We find that the model can simultaneously explain prices on CDX senior tranches and on equity index options at parameter values that are consistent with the equity premium and with aggregate stock market volatility. Our results demonstrate the importance of beliefs about rare disasters for asset prices, even during periods of relative economic stability.

Suggested Citation

  • Sang Byung Seo & Jessica A. Wachter, 2016. "Do Rare Events Explain CDX Tranche Spreads?," NBER Working Papers 22723, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:22723
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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