The valuation of collateralised debt obligations: multi-period modelling in a risk-neutral framework

Abstract

For over fifty years, mortgages have been securitised by selling the rights to the mortgage cash flows to third party investors. Over the past ten years or so, a similar securitisation process has been undertaken with corporate debt. The claims on the cash flowing from the corporate debt portfolio are called collateralised debt obligations (CDO). CDO cash flows are dependent on the interaction of a portfolio of debt securities over many time periods. They are particularly sensitive to the correlation among the underlying secunties and to the terms of the indenture. While much progress has been made in modelling debt portfolios over a single period, there has been a lot less published about the interaction of debt secunties m a portfolio over many penods. This thesis develops a model for valuing CDOs using a nsk-neutral approach in a multiperiod setting. A model is also developed which reproduces Moody’s CDO rating. The Moody’s rating is compared to that which is implied from applying the nsk-neutral model, the differences analysed and the implications for regulatory capital for CDOs explored