CDOs in the Light of the Current Crisis

FINANCIAL RISKS: NEW DEVELOPMENTS IN STRUCTURED PORDUCT & CREDIT DERIVATIVES, C. Gourieroux and M. Jeanblanc, EDS., Chapter 4, pp.33-48, Economica

12 Pages Posted: 3 Jul 2008 Last revised: 15 Dec 2010

See all articles by Raquel M. Gaspar

Raquel M. Gaspar

ISEG and Cemapre/REM, Universidade de Lisboa

Thorsten Schmidt

University of Freiburg

Date Written: 2009

Abstract

This paper proposes a top-down model for pricing Collateralized Debt Obligation CDOs). Our proposal is both treatable and realistic, in the sense we are able to obtain closed-form solutions to single tranche CDOs and capturing extreme credit events. We use as key ingredients the so-called (T, x)-bonds, as proposed in Filipovic, Overbeck, and Schmidt (2008), but generalize their affine specification byincluding shot-noise processes. Our claim is that affine diffusions combined with shot-noise processes lead to an improved modeling of CDO spreads in comparison to existing affine jump-diffusion models. The proposed approach allows in particular for better capturing the possibility of extreme events, like the ones underlying the current crisis. We illustrate our results with a very concrete (simple) instance of our class of models. Finally, we identify the connections between the top-down and bottom-up approaches for modeling credit risk, within our class of models. In particular, we show that even when taking a bottom-up approach the aggregate loss process would be a process of affine shot-noise type.

Keywords: CDOs, credit risk, Affine, Shot-noise, Top-down

JEL Classification: G12

Suggested Citation

Gaspar, Raquel M. and Schmidt, Thorsten, CDOs in the Light of the Current Crisis (2009). FINANCIAL RISKS: NEW DEVELOPMENTS IN STRUCTURED PORDUCT & CREDIT DERIVATIVES, C. Gourieroux and M. Jeanblanc, EDS., Chapter 4, pp.33-48, Economica , Available at SSRN: https://ssrn.com/abstract=1155107

Raquel M. Gaspar (Contact Author)

ISEG and Cemapre/REM, Universidade de Lisboa ( email )

Rua Miguel Lupi, 20
room 510
Lisbon, 1249-078
Portugal

Thorsten Schmidt

University of Freiburg ( email )

Fahnenbergplatz
Freiburg, D-79085
Germany

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