Keywords: Credit derivatives, credit risk, collateralized debt obligation
Abstract: Synthetic collateralized debt obligations, or synthetic CDOs, are popular vehicles
for trading the credit risk of a portfolio of assets. Following a brief summary of the
development of the synthetic CDO market, I draw on recent innovations in modeling to present
a pricing model for CDO tranches that does not require Monte Carlo simulation. I use the
model to analyze the risk characteristics of the tranches of synthetic CDOs. The analysis
shows that although the more junior CDO tranches -- equity and mezzanine
tranches -- typically contain a small fraction of the notional amount of the CDO's reference
portfolio, they bear a majority of the credit risk. One implication is that credit risk
disclosures relying on notional amounts are especially inadequate for firms that invest
in CDOs. I show how the equity and mezzanine tranches can be viewed as leveraged exposures
to the underlying credit risk of the CDO's reference portfolio. Even though mezzanine
tranches are typically rated investment-grade, the leverage they possess implies their
risk (and expected return) can be many times that of an investment-grade corporate bond.
The paper goes on to show how CDO tranches and other innovative credit products, such
as single-tranche CDOs and first-to-default basket swaps, are sensitive to the correlation of
defaults among the credits in the reference portfolio. Differences of opinion among market
participants as to the correct default correlation can create trading opportunities. Finally,
the paper shows how the dependence of CDO tranches on default correlation can also be
characterized and measured as an exposure to the business cycle, or as "business cycle risk."
A mezzanine tranche, in particular, is highly sensitive to business cycle risk.
Full paper (168 KB PDF)
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Last update: July 23, 2004