Pricing and Hedging Synthetic CDO Tranche Spread Risks

20 Pages Posted: 18 Mar 2009 Last revised: 1 Apr 2009

Michael Sherris

University of New South Wales - ARC Centre of Excellence in Population Ageing Research and School of Risk and Actuarial Studies; UNSW Australia Business School

Jie Ding

Macquarie University

Date Written: March 16, 2009

Abstract

The recent credit crisis has focussed attention on the models used for pricing and assessing risk of structured credit transactions including bespoke CDO's. There are many models that have been proposed for pricing bespoke CDO's including the base correlation mapping methods with the market standard Gaussian copula model as well as the implied copula models. Methods commonly used in the market for hedging and pricing bespoke CDO's make explicit assumptions for the relationship between default probability and default correlation and calibrate the model to current CDO prices only. The ability of a model to hedge CDO tranche spread risks using a credit index is closely related to it's ability to price CDOs on bespoke portfolios. This paper examines the measurement and hedging of synthetic CDO tranche spread risks based on market spread data following the sub-prime crisis. A range of methods proposed for pricing bespoke CDOs are examined to assess their ability to hedge the credit spread risk. The methods assessed are calibrated to the traded CDO index spread and then compared based on the mean absolute pricing errors over a time period including the sub-prime crisis. Standard pricing methods and variations used to price bespoke CDOs generally perform poorly in hedging credit spread risk. Past data can be used to improve the performance of the methods. The results of this analysis also raise concerns with the accuracy of "mark-to-model" valuations of bespoke CDOs using standard market methods.

Keywords: credit risk, CDO, Gaussian copula, base correlation, implied copula

JEL Classification: G01, G13

Suggested Citation

Sherris, Michael and Ding, Jie, Pricing and Hedging Synthetic CDO Tranche Spread Risks (March 16, 2009). UNSW Australian School of Business Research Paper No. 2009ACTL04. Available at SSRN: https://ssrn.com/abstract=1361342 or http://dx.doi.org/10.2139/ssrn.1361342

Michael Sherris (Contact Author)

University of New South Wales - ARC Centre of Excellence in Population Ageing Research and School of Risk and Actuarial Studies ( email )

Australian School of Business
Quadrangle Building
Sydney, NSW 2052
Australia
+61 2 9385 2333 (Phone)
+61 2 9385 1883 (Fax)

HOME PAGE: http://www.asb.unsw.edu.au/schools/Pages/MichaelSherris.aspx

UNSW Australia Business School ( email )

Sydney, NSW 2052
Australia

Jie Ding

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

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