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An Empirical Analysis of the Pricing of Collateralized Debt Obligations

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  • Francis A. Longstaff
  • Arvind Rajan

Abstract

We study the pricing of collateralized debt obligations (CDOs) using an extensive new data set for the actively-traded CDX credit index and its tranches. We find that a three-factor portfolio credit model allowing for firm-specific, industry, and economywide default events explains virtually all of the time-series and crosssectional variation in CDX index tranche prices. These tranches are priced as if losses of 0.4, 6, and 35 percent of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65 percent of the CDX spread is due to firm-specific default risk, 27 percent to clustered industry or sector default risk, and 8 percent to catastrophic or systemic default risk. Recently, however, firm-specific default risk has begun to play a larger role.

Suggested Citation

  • Francis A. Longstaff & Arvind Rajan, 2006. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," NBER Working Papers 12210, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:12210
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    1. Duffie, Darrell & Saita, Leandro & Wang, Ke, 2007. "Multi-period corporate default prediction with stochastic covariates," Journal of Financial Economics, Elsevier, vol. 83(3), pages 635-665, March.
    2. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    3. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
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    5. Sanjiv R. Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2007. "Common Failings: How Corporate Defaults Are Correlated," Journal of Finance, American Finance Association, vol. 62(1), pages 93-117, February.
    6. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," The Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    7. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
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    • G1 - Financial Economics - - General Financial Markets

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