capital 40
derivatives world
Pricing of a CDO
rom the previous
article, we begin
to appreciate the
complexity of the
CDO. However, its
most complex as-
pect by far would be its pricing.A CDO
is constructed with a pool of securi-
ties, thus, its valuation is dependent
on every asset in the pool and the
correlation between them. Numerous
papers have been (and still are being)
written about the pricing of the CDO,
primarily modelling the dependent
default structure.
CDO models
While the first CDOs were issued as
early as 1987, they emerged in the se-
curities market only in the late 1990s.
As such the basic infrastructure for
CDO pricing is at its infancy.
CDO pricing is a function of the
correlation between the default risks
of all assets in the reference portfolio.
Theories differ on how to estimate
or model these correlated defaults.
Copula models attempt to get implied
correlation from the market to price
bespoke CDO tranches. Others prefer
to dynamically model the loss of the
bespoke portfolio with stochastic mod-
els using calibrated parameters.
Copulas are one of the methodolo-
gies that first caught the attention of
most market practitioners to model
the dependency structure in the asset
portfolios. Despite its drawbacks, the
by
Jasvin Josen
main reason for its wide usage is its ease
of implementation and calibration.
CDO pricing steps
The focus here however is to discuss
the methodology in pricing a CDO and
not its model choice and pitfalls. For
ease of explanation, the 1-factor Gaus-
sian Copula is chosen. Readers who
are not interested in the nitty gritty of
the pricing may skip to the paragraph
titled “The Abacus Case” to catch the
highlights of CDO valuation.
Pricing of a CDO is explained by
the following steps:
i) Obtain the implied correlation
from the market
ii) Model the dependent default
times
iii) Compute the pool Expected Loss
(EL)
iv) Compute the Tranche EL
v) Price the CDO tranche
(i) Obtain the implied correlation
from the market
Standardised index CDOs in the mar- time and constant across assets.
ket like the CDX and iTraxx have quot-
ed bid and offer prices. The tranche (ii) Model the dependent default
prices are put in the Gaussian Copula times
Model and the model works in reverse The whole crux in valuing a CDO is es- model is to arrive at dependent default
to back out the implied correlations.In timating when the assets in the CDO times. Dependent because correlation
Chart 1: Copulas to generate correlated default times
Independent uniform random numbers Transform uniform into normal numbers then impose correlation
1 12
12
0
1
Translated survival rate into default Map the correlated normals back to uniform numbers,
probabilities using individual default curve representeing correlated survival rates
1 1
0.6
0.6
0 Default time
for Asset 1
6-yr
time 0
this model, correlation is flat, mean- will default. For example, if the CDO is
ing that the correlation is constant in of 5-year maturity and most assets are
estimated to default only between 7 to
20 years,then the tranches have low risk
and would command low spreads.
The objective of the Gaussian Copula
exists between the assets in the pool,
hence one asset’s default could be de-
pendent on the other. We start with
generating random numbers between
0 and 1, representing survival rate of
assets. Then we impose the implied
correlation obtained from the market
to obtain correlated normal random
numbers.The normal numbers are once
again transformed into uniform num-
bers to represent correlated survival
rates of the assets in the pool.Finally we
translate these correlated survival rates
into default times using the individual
asset’s credit curves. The whole depic-
tion is illustrated in Chart 1.
iii) Compute the Pool EL
In Chart 2,say we have a two-asset port-
folio example. Assume that the de-
fault time of the assets in Column A
are already modelled. Now the EL of
each asset is calculated as [Notional*
(1-recovery rate)]. The EL of both as-
sets is combined to obtain the pool
EL in Column C. From the simulated
default times, many simulations of
pool EL is obtained. If we were to plot
PVcontingent leg =
all the simulated pool EL in a graph, t
we would get a typical portfolio loss
distribution discussed in my previ-
ous article.
PVfee leg =
iv) Compute the Tranche EL
Let us look at a CDO with a total no-
tional of 100m and its 10%-25% tranche
(see Chart 3). As defaults occur, there
can be one of three consequences for
the tranche:
a) No losses reaches the 10-25%
tranche
b) Losses reaches the 10-25% tranche
c) Losses exceed the 10-25% tranche
Back to the table in Chart 2,say we have
a 10-25% tranche.For simulation (1) both
default times occurred after the 5-year
maturity of the CDO, so default is zero
for both the pool and the tranche. In
simulation 2,both asset 1 and 2 happen
to default before five years. The pool
THEEDGE mal aysia   |  june 7, 2010
CDO Models: Opening the Black Box, Dresdner Kleinwort, October 2008
12
12
1
loss is $62 million; this means that the
equity and 10-25% tranches are fully
wiped out. In simulation 3, only As-
set 1 defaults before the CDO maturity
which causes the 10-25% tranche EL to
be affected partially to the tune of $4
million ($14 million - $10 million equity
tranche loss)
We can summarise the tranche EL
into one algorithm to capture the EL of
a tranche in all three situations:
Tranche EL (i) = max [(min(A (1-rec)),
det) – att), 0]
Where
i = the tranche
A = Pool EL
Rec = recovery rate
Det = notional at detachment
point (in this case $25m)
Att = notional at attachment
point (in this case $10m)
v) Price the CDO Tranche
A CDO tranche is priced by simply
computing the present value (PV) of
its two legs, the premium leg (paid
by the protection buyer) and the con-
tingent leg (paid by the protection
seller in the event of a default). For
each simulated tranche loss in Chart
2 (column D), the PV of the fee and
contingent leg will be calculated us-
ing the formulae given:
0
∫
[df (t) ∗ (TranchEL(t)−TrancheEL(t−1))]
s∗ ∑df ( t)[( H − L ) − TrancheEL(t) ]
Where
t = point in time
H = Notional at the detachment
point = $25m
L = The Notional at the attach
ment point =$10m
s = fixed coupon of
the tranche
df = Fee Leg: discount rate for each
payment period (Fee leg) / Contingent
Leg: discount rate(s) at the estimated
default dates
Intuitively the PV of the premium
leg is just the premium rate multiplied
by the notional of the tranche for every
payment period.For each payment pe-
THEEDGE mal aysia   |  june 7, 2010 41

Conclusion
Chart 2: Computation of Pool and Tranche EL Chart 3 The Abacus event was tragic but at
least it has taught us some interest-
Total Notional= $100m ing technical aspects.We acknowledge
A B C D how funded transactions are crucial in
Estimated Default Default time Pool EL ($m) 10-25% Tranche EL minimising counterparty risk.One can
Simulations time less than maturity (before discounting) (before discounting) also appreciate the significance of loss
of 5 yrs?
Asset 1 Asset 2 Note 1 ($m) distributions in figuring out how risky a
1 6 yr 10 yr NO 0 0 CDO is.We also have come to terms with
2 4.5 yr 2 yr YES (both) 62 25 pricing of a CDO to recognise how the
25% main drivers, defaults and correlation
3 3 yr 8 yr YES (Asset 1) 14 4
15m act together to impact its value.
After the financial crisis,many prac-
titioners realised how far off their pric-
10%
ing models were,when values of CDOs
10,000 10m plunged in the market. One of the is-
0% sues was that the correlation skew,
Note 1 the difference between the modelled
Notional Recovery Loss and market correlation (just like the
$ (m) rate seller, the value of the CDO tranche volatility smile in the Black Scholes
Asset 1: 20 0.3 20 (1-0.3) = 14 in its books would be + PV (premium world) was not captured properly.
Asset 2: 80 0.4 80 (1-0.4) = 48 leg) – PV (contingent leg). The high More focus is being given to other
100 62 negative PV of the contingent leg copulas that capture better tail risk (or
pushed down the tranche’s mark-to- remote events) and dynamic models
Asset 1: 20 0.3 20 (1-0.3) = 14 market value. with dynamic correlation surface to
Asset 2: 80
It is a wonder how the 50-100% produce better models.After an event-
100 14
tranche of the same CDOs was valued ful decade of a rise and a fall, hope-
in ACA Capital’s books,considering that fully the CDO will now mature into
it willingly entered into such a deal. an instrument with robust pricing
Besides admitting to the cumber- and risk management.
riod,the notional is evaluated to see if it The Abacus case prime loans coupled with high cor- some process involved in pricing a
has decayed when defaults occurred.As If we go back to the Abacus’s case, relation led to very near default times CDO, the above points out that the Jasvin Josen is a specialist in
for the contingent leg,the PV is simply Goldman wrote down its unhedged in the model. Events have shown that main driver of CDO valuation is how developing methodologies for the
the EL of the tranche that the PS has to 45%-50% portion about a week after correlation tends to get stronger as dependent the defaults are in the valuation of various credit products.
make good to the PB upon default.The the transaction was completed. Going asset quality worsens. reference portfolios. This in turn de- She has over 10 years’ experience
calculation takes place in a continuous back to the above valuation principles, This triggered massive pool EL pends on the steepness of default in investment banking and the
time period (and not discrete) thus the it must be the case where the steep which ate through the 45-50% tranche curves (credit quality) and correlation financial industry in Europe and
use of integration in the formulae. individual default curves of the sub- very quickly.As GS was the protection among the assets. Asia. Comments: jasvin@gmail.com.