Substitution Costs in Managed Synthetic CDOs

19 Pages Posted: 3 Dec 2013

See all articles by Dominic O'Kane

Dominic O'Kane

EDHEC Business School - EDHEC Risk Climate Impact Institute

Date Written: December 2, 2013

Abstract

Managed synthetic CDOs permit the dynamic substitution of credits in the reference portfolio. The expectation of investors in is that a skilled manager should be able to identify deteriorating credits before they experience a credit event and should therefore be able to remove the credit from the portfolio at a lower cost than the loss due to a credit event. This ability to substitute credits has a cost and in this paper we explain the source of this cost and calculate it across a wide range of CDO deal scenarios using a Gaussian copula correlation model. In deals where the cost is transformed into a change in subordination, we show that in it is possible to estimate this change without use of a correlation model. We also describe an extension of Vasicek's portfolio model that allows us to improve upon this estimate. We also incorporate the effect of transaction costs into the substitution cost and calculate their size across a range of CDO parameters. Our aim is to enhance transparency around the cost of substitutions.

Keywords: CDS, CDS Indices, CDO, Gaussian Copula, Base Correlation

JEL Classification: G12, G13, G18, C6

Suggested Citation

O'Kane, Dominic, Substitution Costs in Managed Synthetic CDOs (December 2, 2013). Available at SSRN: https://ssrn.com/abstract=2362477 or http://dx.doi.org/10.2139/ssrn.2362477

Dominic O'Kane (Contact Author)

EDHEC Business School - EDHEC Risk Climate Impact Institute ( email )

United Kingdom

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