EconStor >
Deutsche Bundesbank, Forschungszentrum, Frankfurt am Main >
Discussion Paper Series 2: Banking and Financial Studies, Deutsche Bundesbank >

Please use this identifier to cite or link to this item:

http://hdl.handle.net/10419/28624
  
Title:Systematic risk of CDOs and CDO arbitrage PDF Logo
Authors:Hamerle, Alfred
Liebig, Thilo
Schropp, Hans-Jochen
Issue Date:2009
Series/Report no.:Discussion Paper Series 2: Banking and financial studies 2009,13
Abstract:“Arbitrage CDOs” have recorded an explosive growth during the years before the outbreak of the financial crisis. In the present paper we discuss potential sources of such arbitrage opportunities, in particular arbitrage gains due to mispricing. For this purpose we examine the risk profiles of Collateralized Debt Obligations (CDOs) in some detail. The analyses reveal significant differences in the risk profile between CDO tranches and corporate bonds, in particular concerning the considerably increased sensitivity to systematic risks. This has farreaching consequences for risk management, pricing and regulatory capital requirements. A simple analytical valuation model based on the CAPM and the single-factor Merton model is used in order to keep the model framework simple. Then, the conditional expected loss curve (EL profile) is studied in some detail. In the next step, the asset correlation associated with a CDO tranche is estimated treating the structured instrument as a single-name credit instrument (i.e., a loan equivalent). While tractable, the loan-equivalent approach requires appropriate parameterization to achieve a reasonable approximation of the tranche´s risk profile. We consider the tranche as a “virtual” borrower or bond for which a single-factor model holds. Then, the correlation parameter is calculated via a non-linear optimization. This “bond representation” allows to approximate the risk profile (expressed by the EL profile) using a single-factor model and to express the dependence on the systematic risk factor via the corresponding asset correlation. It turns out that the resulting asset correlation is many times higher than that of straight bonds. Then, the Merton type valuation model for the corresponding bond representations is applied for valuation of the CDO tranches. Using a sample CDO portfolio, some opportunities for “CDO arbitrage” are described where it is assumed that investors are guided solely by the tranches’ rating and ignore the increased systematic risk for pricing. In the next section we discuss how tranches with high systematic risk can be generated and how CDO arrangers can exploit this to their advantage. It comes as no surprise that precisely these types of structures featured in many of the CDOs issued prior to the outbreak of the financial crisis.
Subjects:Collateralized debt obligations (CDO)
arbitrage CDOs
credit rating
expected loss profile
bond representation
systematic risk of CDO tranches
CDO pricing
JEL:C13
G01
G12
G24
ISBN:978-3-86558-571-4
Document Type:Working Paper
Appears in Collections:Discussion Paper Series 2: Banking and Financial Studies, Deutsche Bundesbank

Files in This Item:
File Description SizeFormat
611927926.pdf417.31 kBAdobe PDF
No. of Downloads: Counter Stats
Download bibliographical data as: BibTeX
Share on:http://hdl.handle.net/10419/28624

Items in EconStor are protected by copyright, with all rights reserved, unless otherwise indicated.