Losses in Investment-Grade Tranches of Synthetic CDO's: A Large Deviations Analysis

Abstract:     
Rare events are an important part of the financial world. For instance, investment-grade financial products by design should suffer losses only rarely. In many cases, this is accomplished by pooling a large number of assets and trancheing the losses. This often leads to a very complex system. We the theory of large deviations, a collection of tools for studying the origination and transformations of rare events, to address some of these issues in losses in senior tranches of synthetic collateralized debt obligations, which in some sense is an archetype of structured finance. Our calculations are fairly self-contained.

Keywords: rare events, synthetic collateralized debt obligations, large deviations

JEL Classifications: C63

Working Paper Series