Understanding the Risk of Synthetic CDOs

By Michael S. Gibson. 2004

132 citations recorded by the source corpus.

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.

Subfields: Economics and Econometrics, Finance, Management Science and Operations Research

View Paper: https://www.semanticscholar.org/paper/1f497ca84386e3fbb31c2540ae9983a5a183e0bd

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Citations in the corpus

Regulatory Capital Charges for Too-Connected-To-Fail Institutions: A Practical Proposal (2010, unknown): “15 See, among others, Gibson (2004) and Hull and White (2004) for a comprehensive description of the onefactor model.”
Systemic Risk Contributions (2011, unknown): “Based on the inputs of the key credit risk parameters—PDs, LGDs, correlations, and liability weights—the systemic risk indicator can be calculated by simulation as described in Gibson (2004), Hull and White (2004), and Tarashev and Zhu (2008b).”
Decomposing European CDS Returns (2010, methodology): “We mimic the setup of the iTraxx Europe (i.e., index formation in March and September of each year, supersenior tranche attachment and detachment points of 12% and 22%, etc.) and use the standard copula-based approach, well reviewed in Gibson (2004), to value index tranches.”
A framework for assessing the systemic risk of major financial institutions (2009, methodology): “Once the two key portfolio credit risk parameters are known, we are able to use the portfolio credit risk methodology (see Gibson (2004), Hull and White (2004), and Tarashev and Zhu (2008a)) to come up with an appropriate indicator of the systemic risk for a pre-defined group of banks.”
Pricing CDOs with Correlated Variance Gamma Distributions (2006, background): “Note that the distributions of M and Zi correspond to the distributions of M1 and Z (i) 1 in (7) and (8) in section 3.”