CDOs and the Financial Crisis: Credit Ratings and Fair Premia
46 Pages Posted: 14 Oct 2011 Last revised: 19 Nov 2012
Date Written: April 28, 2011
We study risk and return characteristics of CDOs using the market standard models. We find that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. Our results imply that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. This illustrates limitations of the rating methodologies that are solely based on real-world payoff prospects and do not incorporate risk premia. We also demonstrate that CDO tranches have large exposure to systematic risk and thus their ratings and prices are likely to decline substantially when credit conditions deteriorate.
Keywords: Collateralized debt obligations, Credit ratings, Fair premia, Structured finance, Rating agencies
JEL Classification: C52, G01, G11
Suggested Citation: Suggested Citation