Synthetic CDO Pricing: The Perspective of Risk Integration

Abstract

The underlying asset pool of collateral debt obligations (CDOs) simultaneously encompasses credit risk and market risk. However, the standard CDO pricing model not only underestimates the risk to the asset pool due to a poor description of the correlation structure among obligors but is also incapable of reflecting the impacts of interdependent markets, credit risks and systematic sudden shocks on the asset pool. This paper studies the joint impact of interrelated market and credit risk factors on the key inputs of CDO pricing (default probability, default correlation and default loss rate) under the framework of factor copula CDO pricing model and constructs a risk-integrated model for CDO pricing. In addition, we extend the static integrated model to a dynamic version by allowing the risk factors driven by the copula-GARCH process. The simulation results show that, compared with an integrated model, the premium of senior tranches is significantly lower under the standard model. Such difference is mainly due to different assumptions of the distributions of risk-driving factor.

Keywords: collateral debt obligation (CDO); risk integration; factor model; copula

JEL Classification: G12; G13; G19