Constant Proportion Debt Obligations (CPDO): Modeling and Risk Analysis

Abstract

Constant Proportion Debt Obligations (CPDOs) are structured credit derivatives indexed on a portfolio of investment grade debt, which generate high coupon payments by dynamically leveraging a position in an underlying portfolio of index default swaps. CPDO coupons and principal notes received high initial credit ratings from the major rating agencies, based on complex models for the joint transition of ratings and spreads for all names in the underlying portfolio. We propose a parsimonious model for analyzing the performance of CPDO strategies using a top-down approach which captures the essential risk factors of the CPDO. Our analysis allows to compute default probabilities, loss distributions and other tail risk measures for the CPDO strategy and to analyze the dependence of these risk measures on various parameters describing the risk factors. Though the probability of the CPDO defaulting on its coupon payments is found to be small, the ratings obtained strongly depend on the credit environment -- high spread or low spread. More importantly, CPDO loss distributions are found to be bimodal and our results also point to a heterogeneous range of tail risk measures inside a given rating category, suggesting that credit ratings for such complex leveraged strategies should be suitably complemented by other risk measures for the purpose of performance analysis. A worst-case scenario analysis indicates that CPDO strategies have a high exposure to persistent spread-widening scenarios. By calculating rating transition probabilities we find that CPDO ratings can be quite unstable during the lifetime of the strategy.

Keywords: CPDO, credit risk, top down models, credit rating, structured product, credit derivatives

JEL Classification: G13