Do Rare Events Explain CDX Tranche Spreads?

90 Pages Posted: 19 Sep 2016 Last revised: 2 Mar 2019

See all articles by Sang Byung Seo

Sang Byung Seo

University of Wisconsin - Madison

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: November 22, 2017

Abstract

We investigate whether a model with time-varying probability of economic disaster can explain prices of collateralized debt obligations. We focus on senior tranches of the CDX, an index of credit default swaps on investment grade firms. These assets do not incur losses until a large fraction of previously stable firms default, and thus are deep out-of-the money put options on the overall economy. When calibrated to consumption data and to the equity premium, the model explains the spreads on CDX tranches prior to and during the 2008-2009 crisis.

Keywords: disaster risk, financial crisis, collateralized debt obligations

JEL Classification: G12, G13

Suggested Citation

Seo, Sang Byung and Wachter, Jessica A., Do Rare Events Explain CDX Tranche Spreads? (November 22, 2017). Forthcoming, Journal of Finance, Available at SSRN: https://ssrn.com/abstract=2839966 or http://dx.doi.org/10.2139/ssrn.2839966

Sang Byung Seo

University of Wisconsin - Madison ( email )

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Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

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