CDOs and the Financial Crisis: Credit Ratings and Fair Premia

46 Pages Posted: 14 Oct 2011 Last revised: 19 Nov 2012

Marcin Wojtowicz

VU University Amsterdam - Department of Finance and Financial Sector Management; Tinbergen Institute - Tinbergen Institute Amsterdam (TIA); Tinbergen Institute

Multiple version iconThere are 2 versions of this paper

Date Written: April 28, 2011

Abstract

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

Wojtowicz, Marcin, CDOs and the Financial Crisis: Credit Ratings and Fair Premia (April 28, 2011). Paris December 2011 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=1944094 or http://dx.doi.org/10.2139/ssrn.1944094

Marcin Wojtowicz (Contact Author)

VU University Amsterdam - Department of Finance and Financial Sector Management ( email )

De Boelelaan 1105
NL-1081HV Amsterdam
Netherlands
+31 20 598 3828 (Phone)

Tinbergen Institute - Tinbergen Institute Amsterdam (TIA) ( email )

Gustav Mahlerplein 117
Amsterdam, 1082 MS
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

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