Risk and Valuation of Collateralized Debt Obligations

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Abstract
In this discussion of risk analysis and market valuation of collateralized debt obligations, we illustrate the effects of correlation and prioritization on valuation and discuss the “diversity score” (a measure of the risk of the CDO collateral pool that has been used for CDO risk analysis by rating agencies) in a simple jump diffusion setting for correlated default intensities. A collateralized debt obligation (CDO) is an asset-backed security whose underlying collateral is typically a portfolio of (corporate or sovereign) bonds or bank loans. A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to prioritized CDO securities (tranches). A standard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower subordinated notes are paid, and any residual cash flow is paid to an equity piece. CDOs form an increasingly large and important class of fixed-income securities. Our analysis may provide useful approaches to valuation and diagnostic measures of risk. We concentrate on cash flow CDOs-those for which the collateral portfolio is not subjected to active trading by the CDO manager. The implication of this characteristic is that the uncertainty regarding interest and principal payments to the CDO tranches is determined mainly by the number and timing of defaults of ...

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