Model Risk and the Design of CDO Tranches

49 Pages Posted: 23 Aug 2010

See all articles by Adam Metzler

Adam Metzler

Wilfrid Laurier University - Department of Mathematics

Date Written: August 20, 2010

Abstract

The goal of this paper is to explore the model risk inherent in the rating and design of structured finance products. We seek to illustrate the consequences of neglecting state-dependent correlations on the methodologies and criteria employed by the major ratings agencies. In contrast to related studies, we focus exclusively on asymptotic analysis. A variety of tractable asymptotics are derived for “first-generation” securitizations, such as asset-backed securities (ABS), as well as “second-generation” securitizations, such as collateralized debt obligations (CDO) backed by tranches of ABS. Consistent with the recent work of Hull and White [2009], who explore alternative sources of model risk, we find that in the case of first-generation securitizations, the implications are substantial but not catastrophic; in the case of second-generation securitizations, however, the implications are dire. This is due to the fact that our analysis provides a parsimonious description of thin mezzanine tranches as “nearly binary” assets which tend to “go bad” at the same time; a phenomenon which is notably absent in the notorious (and industry standard) Gaussian factor models.

Keywords: Credit ratings, stochastic correlation, random factor loadings, credit risk, asset-backed securities, collateralized debt obligations, structured finance

JEL Classification: G20, G24

Suggested Citation

Metzler, Adam, Model Risk and the Design of CDO Tranches (August 20, 2010). Available at SSRN: https://ssrn.com/abstract=1662660 or http://dx.doi.org/10.2139/ssrn.1662660

Adam Metzler (Contact Author)

Wilfrid Laurier University - Department of Mathematics ( email )

Canada

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