A Dynamic Affine Factor Model for the Pricing of Collateralized Debt Obligations

Abstract

We propose an affine two-factor model for the pricing of single-tranche collateralized debt obligations by following the general top-down framework introduced in Filipovic et al. [2011]. Apart from being analytically tractable, this model has the feature that it incorporates a catastrophic risk component as a tool to capture the dynamics of super-senior tranches. To appraise the actual performance of the model we run an estimation analysis based on the quasi-maximum likelihood approach in conjunction with the Kalman filter. Our findings suggest that the two-factor model is successful in describing the iTraxx Europe data set which covers the time period including the recent credit crisis.

Keywords: collateralized debt obligations, single-tranche CDO, affine term-structure of credit spreads, catastrophic risk

JEL Classification: C51, G12