A Decade of CDO Pricing

World Congress on Computational Finance

Jon Gregory
Jon.Gregory@barcap.com
March 26th 2007
Growth of Structured Credit Products

35 Credit Derivative Notional Outstanding

Leveraged super senior,

30 Bespoke Managed CDOs; Equity Default
Swaps; Constant Maturity Default Swaps;
CPPI and CPDO

Interest Rate Hybrids

25 Single Tranche CDOs;

Managed CDOs; CDS Recovery Swaps; Dow
Indices Jones CDX/iTraxx
Tranche Trades
Options; Capital
$ Trillion

20 Synthetic
Arbitrage CDOs
Structure
Arbitrage; CDO2
Cash Flow
15 Structured Finance
CDOs

10 Synthetic Balance Sheet

CDOs; Nth-to-Default
Baskets

0
1996 1998 1999 2000 2001 2002 2003 2004 2006 2008E

Note: Notional excludes asset swaps

Source: British Bankers Association Credit Derivatives Report 2006; Barclays Capital Credit Research

2
Before the Correlation
Market
The Gaussian Copula Model
The Gaussian copula model
 Construction of default times consistent with marginal credit curves

 Typically via a single correlation parameter (1F)

 Fast semi-analytical formulas for pricing and greeks

Typical trade, long mezzanine protection, delta hedged

 Positive carry trade

 Short Idiosyncratic default risk

 Gamma
— Short idiosyncratic gamma

— Long parallel gamma

Manifestation of
correlation risk

15%

10%
Parallel gamma
Delta hedged PV

5%

0%
0

-5% Idiosyncratic gamma

-10%

Default
-15%
Spread move
4
Gaussian Copula Model in Action
16%

14%

12%

10%
Probability

8%

6%

4%

2%

0%

10
11
12
13
14
15

17
18
19
20
21
22
23
24
25
26
-3

-1

16
-2

1
2
3
4
5
6
7
8
9
P&L

Many sudden credit Several credit events Few credit events

events occurring early

Hedging simulation of [3-6%] long protection position, delta hedged only

5
Model Risk : Choice of Copula
From first to last to default swap premiums (bp pa)

Gaussian Student-t copula Student-t copula Clayton Marshall-Olkin

Rank
Copula (6 dof) (12 dof) Copula Copula

1 723 723 723 723 723

2 277 278 276 274 160

3 122 122 122 123 53

4 55 55 55 56 37

5 24 24 25 25 36

6 11 10 10 11 36

7 3.6 3.5 4.0 4.3 36

8 1.2 1.1 1.3 1.5 36

9 0.28 0.25 0.35 0.39 36

10 0.04 0.04 0.06 0.06 36

10 names, spreads from 60 bps to 150 bps, recovery = 40%,

maturity = 5 years, Gaussian correlation = 30%
6
Black Scholes compared to GCM

Black-Scholes Gaussian Copula Model

- Dynamic Model describing evolution of - Static representation of default times
underlyings
- Obvious economic intuition - Economics not obvious (tenuous intepretation via
Merton model)

- Price defined by unique replicating portfolio - Replicating portfolio more complicated and not
tradeable

- Delivered volatility  Price - Delivered correlation is a complex function of

greeks (gamma, realised defaults)

- Natural extensions (e.g. stochastic volatility) - Not so obvious how to extend and overcoming
linked to observation of market implied skew shortcomings

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The Correlation Skew
Standard Index Tranches
The growth of the index market has led the development of liquid tranched credit markets

Tranches of the Dow Jones CDX and iTraxx portfolios are now traded as liquid products to allow
investors to express views on credit spread and default risk.

DJ iTraxx Europe Tranched DJ iTraxx Europe

Super Senior 22-100%

125 equally weighted names

12-22%
9-12%

6-9%

3-6%

Equity 0-3%

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 A Traded Correlation Market

Market GCM
Super Senior 22-100% 3.53 0.05
8.75 6.99
14.0 32.9
12-22%
26.5 82.0
9-12%

6-9%
82.5 234.7
3-6%

Equity 0-3% 24.00% 19.3%

Dependency is defined by a single correlation parameter

 No concept of idiosyncratic default
 No concept of systemic default

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Base Correlation

y
 

60%

50%

40%

30%

20%

10%

0%
[0-3%] [0-6%] [0-9%] [0-12%] [12-22%]

CDO[4%,8%]  CDO[0,4%;  4% ]  CDO[0,8%; 8% ]

11
Base Correlation – Interpolation and Extrapolation

Base Correlation Curve “Tranchelet” Premiums

10,000
50%

45%

40%
1,000
35%
Base Correlation

30%

Premium (bps)
25% 100

20%

15%

10% 10

5%

0%
0% 5% 10% 15% 20% 25% 30% 1
0% 5% 10% 15% 20% 25% 30%
Base Tranche Detachment
Tranche Detachment

[16-17%] tranchelet

12
Arbitrage-free Loss Interpolation
Build base tranche expected loss curve as attachment point increases
Restrictions to be arbitrage-free
 Must be increasing (tranche expected tranche losses cannot be negative)
 Must be concave (a more senior tranche cannot be more risky)
 Must eventually hit index level (before 100%)

Tranches Index

5.0%
4.5%
4.0%
Cumulative Expected Loss

3.5%
3.0%

2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0% 5% 10% 15% 20% 25% 30% 35%
Attachment point of base tranche

13
Tranchelet Pricing – Some Extremes
[0-3%] equity tranche  [0-1%], [1-2%] and [2-3%] tranchelets
Minimum concavity, systemic risk effect

0-1% 1,201
1-2% 1,201
2-3% 1,201

3 6

Maximum concavity, maximum dispersion, idiosyncratic risk

aln

0-1% 3,090
tio
no

1-2% 1,214
e
ch

2-3% 61
an
Tr

3 6 3 6

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Pricing Tranchelets
We know for example [0-3%] and [3-6%]
Where would we price [0-1%], [1-2%], [2-3%], [3-4%], [4-5%] and [5-6%] ?

45%

40%
- All fit the 2 market prices
35%
- All are arbitrage-free
30%
Base Correlation

25%

20%

15%

10%

5%

0%
0-1% 1-2% 2-3% 3-4% 4-5% 5-6%

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CDO Models
CDO Models
Many Examples

Extensions to Gaussian copula model

 Random factor loadings / local correlation

 Stochastic correlation
 Double-t / Double-NIG

 Levy process / intensity gamma

Dynamic models
 Stochastic intensity models

 Dynamic loss models

Typically quite hard to fit the market

Implied copula

17
Difficulty in fitting the market
Market Model

70%
Implied Compound Correlation

60%

50%

40%

30%

20%

10%

0%
[0-3%] [3-6%] [6-9%] [9-12%] [12-22%] [22-100%]

18
The Toothpaste Tube Analogy

Super Senior 22-100%

Index
[0-100%]
12-22%
9-12%

6-9%

3-6%

Equity 0-3%

Index = Sum of tranches

[22-100%] = [0-100%] – [0-3%] – [3-6%] – [6-9%] – [9-12%] – [12-22%]

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The Toothpaste Tube Analogy (II)
Not really correct
 Small changes in equity default timing assumptions can change the size of the tube….

Upper Bound (0% rec) Upper Bound (40% rec) Lower Bound Implied from 3Y

100%

90%

80%
[22-100%] > [12-22%]
Relative EL in equity

70%

60%

50% [22-100%] = 0
40%

30%

20%

10%

0%
0 1 2 3 4 5
Maturity

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Fitting the Market - Summary
For hedging purposes need to fit tranches and index

Super senior risk causes real problems

 [22-100%] tranche can withstand 45 credit events at 40% recovery – very out of the money

 Must have flexibility over timing of credit events

 Shouldn’t try and boostrap the market

— example : 7Y equity gives information about 5Y super senior

— example : 5Y equity tranchelets give information about 10Y equity

Very technical market

 Leveraged super senior issuance can move equity premiums

 Dislocation between maturities

Greeks
 If we don’t fit precisely how can we characterise / calculate greeks?

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Bespoke Tranches – Normalisation Methods
If the portfolio is more risky then an equivalent tranche is more risky

How to we adjust the correlation curve we use to account for this?

Index portfolio Bespoke portfolio

Tranche

Expected loss

22
Bespoke Tranches – Normalisation Methods (II)

Index Bespoke

50%
45%
40%
35%
Correlation

30%
25%
20%   EL  
 bespoke (k )   index   index  
k
15%   ELbespoke  
10%
  
5%
0%
0% 10% 20% 30% 40%
Base Tranche Detachment point

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Structural Models Lead only one way
Implied Copula Approach (Hull and White)
 Can fit index tranche market perfectly

 Bespoke prices are not uniquely defined

Market Implied Stochastic Correlation

60% 14%

50% 12%

Default Probability (market

Default Probability (GM)

10%
40%
8%

implied)
30%
6%

20%
4%

10% 2%

0% 0%
0% 3% 5% 8% 10% 20% 70%
Probability

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The Future
Index Correlation – off the run tranches
Index rolls give us more maturity information

5Y 7Y 10Y
CDX.4 CDX.5 CDX.6 CDX.7 CDX.8 CDX.5 CDX.6 CDX.7 CDX.8 CDX.4 CDX.5 CDX.6 CDX.7 CDX.8
CDX.4

80%

70%

60%

50%
correlation

40%
“Base Correlation”
30%
Surface
20%

10%

0%
3.75
4.25
4.75
5.25
5.75
6.25
6.75
7.25

30%
8.75

15%
9.25

10%
9.75
matu

7%
10.25
r ity

3%
et ach
d 26
Index Correlation – HY/IG
Different indices may provide complimentary information

CDX IG CDX HY 80%

70%

[0-3%] [0-10%] 60%

50%
[3-7%] [10-15%]

Correlation
40%

[7-10%] [15-25%] 30%

20%

[10-15%] [25-35%] 10%

0%
[15-30%] 0% 5% 10% 15% 20% 25% 30% 35% 40%
Detach

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Index Correlation – HY/IG (II)
Test out your pricing method

HY
10% 15% 25% 35%

IG
3%

HY

IG
3% 7% 10% 15% 30%

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Index Correlation – HY/IG (III)

CDX IG CDX HY 80%

70%

[0-3%] [0-10%] 60%

50%
[3-7%] [10-15%]

Correlation
40%

[7-10%] [15-25%] 30%

20%

[10-15%] [25-35%] 10%

0%
[15-30%] 0% 5% 10% 15% 20% 25% 30% 35% 40%
Detach

Obvious implications for Barbell portfolios

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Bespoke CDO Pricing
Many possible mapping techniques / models to go from index to bespoke

Shouldn’t really be expecting a unique solution

 Bespoke portfolio may not overlap / share characteristics with index from which it is valued

Better approach to look at the whole picture

—IG / HY / XO tranches

—On-the-run and off-the-run tranches

—Different regions spread

HY
tranches

XO
tranches
MODEL
Bespokes

Maturity

iTraxx.5 iTraxx.6 iTraxx.5 iTraxx.6 iTraxx.5 iTraxx.6

5Y 5Y 7Y 7Y 10Y 10Y

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 Product Development
Exotic Payoffs



Cross-region, cross-asset

Long/short
Payoffs only depend on default times
 IO/PO structures
 CDO^2

Forward correlation
 Forward starting CDO
 Amortising CDO

Options
 Tranche options
 Leveraged super senior tranches

Large area of interest tackling these exotic

CDOs

Base correlation, implied copula approach

Now we need a model based approach that

can characterise maturity term structure

Payoff sensitive to credit spread distributions

aswell as default times

Stochastic Intensity and Dynamic Loss Models

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The Challenges and Solutions

Tranchelet pricing Loss Surface Construction

Bespoke Pricing Enhanced Base Correlation Methods

“Exotic” CDOs Implied Copula Approach

Forward Starting Stochastic Intensity Models

Tranche Options Dynamic Loss Models

There is no one to one mapping in the above  Tranche options pricing may be very sensitive to tranchelet pricing

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Disclaimer
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