Valuation of a Cashflow CDO Without Monte Carlo Simulation

25 Pages Posted: 16 Sep 2009  

Donal A. Gallagher

Quaternion Risk Management

James P. Gleeson

University of Limerick, Ireland

Chris Kenyon

Lloyds Banking Group

Roland Lichters

Quaternion Risk Management

Date Written: September 15, 2009

Abstract

Unlike tranches of synthetic CDOs, that depend only on the defaults of the underlying securities, tranches of cashflow CDOs also depend on the interest cash flows from the coupons of the securities. Whilst fast, accurate, (semi-)analytic methods exist for pricing synthetic CDO tranches (Hull and White 2004), no equivalent methods exist for pricing cashflow CDO tranches because of their dependence on both principal and interest waterfalls. We introduce an analytical approximation that renders cashflow CDOs amenable to (semi-)analytic pricing. The complication of needing the joint distribution of interest and outstanding notional is reduced to needing only their marginal distributions. We show that our analytic approximation is globally valid with bounded errors that are small in most cases. Furthermore, our approach can be extended to more detailed structural features such as interest coverage tests and over-collateralization tests. We present results from realistic cashflow CDO examples.

Keywords: cashflow CDO, CLO, tranche, pricing, derivatives, credit, Monte Carlo, simulation

JEL Classification: G12, G13, G21, G24, G16, C15, C63

Suggested Citation

Gallagher, Donal A. and Gleeson, James P. and Kenyon, Chris and Lichters, Roland, Valuation of a Cashflow CDO Without Monte Carlo Simulation (September 15, 2009). Available at SSRN: https://ssrn.com/abstract=1473737 or http://dx.doi.org/10.2139/ssrn.1473737

Donal A. Gallagher (Contact Author)

Quaternion Risk Management ( email )

54 Fitzwilliam Square
Dublin 2
Dublin
Ireland

HOME PAGE: http://www.quaternion.com

James P. Gleeson

University of Limerick, Ireland ( email )

MACSI
Dept of Mathematics and Statistics
Limerick
Ireland

HOME PAGE: http://www.ul.ie/gleesonj

Chris Kenyon

Lloyds Banking Group ( email )

10 Gresham Street
London, EC2V 7AE
United Kingdom

Roland Lichters

Quaternion Risk Management ( email )

54 Fitzwilliam Square North
Dublin, D02X308
Ireland

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