CDO Pricing
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Collateralized debt obligations (CDOs) are gaining wide acceptance among investors as these are constructed with multiple securities, helping to diversify risks. In fact, CDOs are typically sold in tranches or levels with different default risk, to suit the varied risk preference of investors. Accordingly, CDO pricing varies for each CDO tranche.[br]
CDO Pricing Issues
Despite the high demand and supply of CDOs in financial markets, basic infrastructure for CDO pricing is still at its infancy. This is predominantly due to the following reasons:
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Infancy of CDOs themselves: Collateralized debt obligations are a relatively new investment vehicle. While the first CDOs were issued as early as 1987, they emerged in the securities market only by the late 1990s.
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Complex CDO structure: Valuation of CDOs is extremely difficult because of their complex and sophisticated structure. Since a CDO is constructed with a pool of securities, its valuation is dependant on every asset in the pool. This increases the probability of estimation errors. Pricing is even more complex in case of CDO squared, which is created with two or more CDOs.
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Lack of resources: While large CDO originators or sellers have built several CDO pricing models, there are limited models or resources on the buy-side (investors). This creates a wide computation or CDO pricing gap between the sell and the buy side.
Finally, while there are several CDO pricing models existing at present, none are completely accurate since they are based on estimations and assumptions.
CDO Pricing: Impact of Default Correlation[br]
CDO pricing is a function of the correlation between the default risks of all assets in the reference portfolio. The valuation of a particular CDO tranche is clearly affected by that of the other. A higher default correlation automatically reduces the value of the lower CDO tranche (senior tranche). This is because a high correlation increases the probability of elimination of the higher CDO tranches, which are equity and mezzanine tranches, increasing the anticipation of losses in the senior tranche.
Conversely, a rising default correlation increases the CDO pricing of the equity tranche, as the correlation is anticipated to reduce after peaking. Finally, the CDO pricing of the mezzanine tranche is unaffected by both situations, which balances each other.
