You are on page 1of 33

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
30 Bespoke Managed CDOs; Equity
Default Swaps; Constant Maturity
senior, CPPI and
CPDO
Default Swaps; Interest Rate
Hybrids
25 Single Tranche
CDOs; Managed Recovery Swaps;
CDOs; CDS Indices Dow Jones
CDX/iTraxx Tranche
Options;
$ Trillion

Trades
20 Synthetic
Arbitrage
Capital
Structure
CDOs
Arbitrage;
Cash Flow CDO2
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 Idiosyncratic gamma
-5%

-10% Default

-15% 4
Gaussian Copula Model in Action
16%

14%

12%

10%
Probability

8%

6%

4%

2%

0%

14

16
17

19
20

22

25
-3
-2

10
11
12
13

15

18

21

23
24

26
-1
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)
Student-t Student-t
Gaussian Clayton Marshall-Olkin
Rank copula copula
Copula Copula Copula
(6 dof) (12 dof)

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 - Static representation of default
of underlyings times
- 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 - Not so obvious how to extend and
volatility) linked to observation of overcoming shortcomings
market implied skew

7
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%

9
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

10
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%; ρ4% ] + CDO [0,8%; ρ8% ]


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% 3
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%
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


al

0-1% 3,090
n
tio
no

1-2% 1,214
e
ch

2-3% 61
an
Tr

3 6 3 6

14
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%] ?

Cublic Spline1 Cubic Spline2 Linear Base Correlation


Quadratic Base Correlation Linear Expected Loss Max Equity Dispersion
Max Mezz Dispersion

45%

40% - All fit the 2 market prices


- All are arbitrage-free
35%

30%
Base Correlation

25%

20%

15%

10%

5%

0%
0-1% 1-2% 2-3% 3-4% 4-5% 5-6%
15
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%]

19
The Toothpaste Tube Analogy (II)
Not really correct
 Small changes in equity default timing assumptions can change the size of the tube….

[22-100%] > [12-22%]


Upper Bound
[22-100%] = 0

100%
20
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?

21
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%   EL  
ρ bespoke (k ) = ρ index   index  
k
20%   ELbespoke  
  
15%
10%
5%
0%
0% 10% 20% 30% 40%
Base Tranche Detachment point

23
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%
24
Probability
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%
correlation

50%
“Base Correlation” 40%
Surface 30%

20%

10%

0%
3.75
4.25
4.75
5.25
5.75

ma
6.25

t ur
6.75

ity
7.25

30%
8.75 ch

15%
ta
9.25

10%
e

9.75
d

7%
26

.25
%
Index Correlation – HY/IG
Different indices may provide complimentary information

CDX IG CDX HY 80%

70%
[0-3%] [0-10%]
60%

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

Correlation
40%
[7-10%] [15-25%]
30%

[10-15%] [25-35%] 20%

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

27
Index Correlation – HY/IG (II)
Test out your pricing method

HY
10% 15% 25% 35%

IG
3%

HY

IG
3% 7% 10% 15% 30%

28
Index Correlation – HY/IG (III)

CDX IG CDX HY 80%

70%
[0-3%] [0-10%]
60%

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

Correlation
40%
[7-10%] [15-25%]
30%

[10-15%] [25-35%] 20%

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

Obvious implications for Barbell portfolios

29
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

30
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
31
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

32
Disclaimer
This presentation has been prepared by Barclays Capital - the investment banking division of Barclays Bank PLC and its
affiliates worldwide (‘Barclays Capital’). This publication is provided to you for information purposes, any pricing in this report
is indicative and is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The information
contained herein has been obtained from sources believed to be reliable but Barclays Capital does not represent or warrant
that it is accurate and complete. The views reflected herein are those of Barclays Capital and are subject to change without
notice. Barclays Capital and its respective officers, directors, partners and employees, including persons involved in the
preparation or issuance of this document, may from time to time act as manager, co-manager or underwriter of a public
offering or otherwise deal in, hold or act as market-makers or advisors, brokers or commercial and/or investment bankers in
relation to the securities or related derivatives which are the subject of this report.

Neither Barclays Capital, nor any officer or employee thereof accepts any liability whatsoever for any direct or consequential
loss arising from any use of this publication or its contents. Any securities recommendations made herein may not be suitable
for all investors. Past performance is no guarantee of future returns. Any modeling or backtesting data contained in this
document is not intended to be a statement as to future performance.

Investors should seek their own advice as to the suitability of any investments described herein for their own financial or tax
circumstances.

This communication is being made available in the UK and Europe to persons who are investment professionals as that term is
defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2001. It is directed at persons
who have professional experience in matters relating to investments. The investments to which is relates are available only to
such persons and will be entered into only with such persons.

Barclays Capital - the investment banking division of Barclays Bank PLC, authorised and regulated by the Financial Services
Authority (‘FSA’) and member of the London Stock Exchange.

Copyright in this report is owned by Barclays Capital (© Barclays Bank PLC, 2004) - no part of this report may be reproduced in
any manner without the prior written permission of Barclays Capital. Barclays Bank PLC is registered in England No. 1026167.
Registered office 54 Lombard Street, London EC3P 3AH. EUxxx

33