Risk and valuation of collateralized debt obligations

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. collateralized debt obligation is an asset-backed security whose underlying collat-eral 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 dif-ferent debt instruments to a prioritized collection of CDO securities, which we call “tranches.” Although many forms of prioritization exist, a stan-dard prioritization scheme is simple subordination: Senior CDO notes are paid before mezzanine and lower subordinated notes are paid, with any resid-ual cash flow paid to an equity piece. We provide some examples of prioritization later in this article