RISK ANALYSIS IN CORRELATION PRODUCTS: CDO'S AS EVIDENCE

Risk Analysis in Correlation Products: Using CDO's as Evidence

ABSTRACT

We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults cluster. A three-factor portfolio credit model explains virtually all of the time-series and cross-sectional variation in an extensive data set of CDX index Tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm-specific default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.

CDOs are important not only to Wall Street, but also to researchers since they provide a near-ideal “laboratory” for studying a number of fundamental issues in Financial economics. For example, CDOs allow us to identify the joint distribution of default risk across firms since CDOs are claims against a portfolio of debt, information that cannot be inferred from the marginal distributions associated with single-name credit instruments. The joint distribution is crucial to understanding how much credit risk is diversifiable and how much contributes to the systemic risk of “credit crunches” and liquidity crises in financial markets. Furthermore, clustered default risk has implications for the corresponding Stocks since default events may map into nondiversifiable event risk in equity markets.

CDO-like structures are emerging as a major new type of financial vehicle and/or “virtual” institution. In particular, the CDO structure can be viewed as an efficient special purpose vehicle for making illiquid assets tradable, creating new risk-sharing and insurance opportunities in financial markets, and compLeting markets across credit states of the world. CDO-like structures are now used not only for corporate bonds and loans, but also for less liquid and more private assets such as subprime home equity loans, credit card receivables, commercial mortgages, auto loans, student loans, equipment leases, trade receivables, small business loans, private equity, emerging market local assets, and even the “intellectual” property rights of rock stars. Finally, observe that a CDO could also be viewed as a “synthetic bank” in the sense that its assets consist of loans and its liabilities run the gamut from near-riskless senior debt to highly leveraged equity. The key distinction, however, is that the “synthetic” CDO bank may not engage in the same type of monitoring activities as actual banks. Thus, a comparison of CDO equity and bank stocks could provide insights into the delegated-monitoring role of financial intermediaries.

The remainder of this paper is organized as follows. Section I provides an introduction to the CDO market. Section II describes the data used in the study. Section III presents the three-factor portfolio credit model. Section IV applies the model to the valuation of index tranches. Section V reports the results from the empirical analysis. Section VI summarizes the results and makes concluding remarks.

Table of Contents

ABSTRACT1

An Introduction to CDOs4

An Example of a Stylized CDO4

Synthetic CDOs7

Credit Default Indexes and Index Tranches7

The Data9

The Model13

Valuing Tranches17

Empirical Analysis18

The Empirical ...