Do Rare Events Explain Cdx Tranche Spreads?

78 Pages Posted: 10 Oct 2016 Last revised: 15 Oct 2016

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: October 2016

Abstract

We investigate whether a model with a time-varying probability of economic disaster can explain the pricing of collateralized debt obligations, both prior to and during the 2008-2009 financial crisis. Namely, we examine the pricing of tranches on the CDX, an index of credit default swaps on large investment-grade firms. CDX senior tranches are essentially deep out-of-the money put options because they do not incur losses until a large fraction of previously stable firms default. As such, these products clearly reflect the market’s assessment of rare-event risk. We find that the model can simultaneously explain prices on CDX senior tranches and on equity index options at parameter values that are consistent with the equity premium and with aggregate stock market volatility. Our results demonstrate the importance of beliefs about rare disasters for asset prices, even during periods of relative economic stability.

Suggested Citation

Seo, Sang Byung and Wachter, Jessica A., Do Rare Events Explain Cdx Tranche Spreads? (October 2016). NBER Working Paper No. w22723, Available at SSRN: https://ssrn.com/abstract=2850257

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Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

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National Bureau of Economic Research (NBER)

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