CDOs and the Financial Crisis: Credit Ratings and Fair Premia
VU University Amsterdam - Department of Finance and Financial Sector Management; Tinbergen Institute - Tinbergen Institute Amsterdam (TIA); Tinbergen Institute
April 28, 2011
Paris December 2011 Finance Meeting EUROFIDAI - AFFI
We study risk and return characteristics of CDOs using the market standard models. We find that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. Our results imply that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. This illustrates limitations of the rating methodologies that are solely based on real-world payoff prospects and do not incorporate risk premia. We also demonstrate that CDO tranches have large exposure to systematic risk and thus their ratings and prices are likely to decline substantially when credit conditions deteriorate.
Number of Pages in PDF File: 46
Keywords: Collateralized debt obligations, Credit ratings, Fair premia, Structured finance, Rating agencies
JEL Classification: C52, G01, G11
Date posted: October 14, 2011 ; Last revised: November 19, 2012
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