Stressing rating criteria allowing for default clustering: the CPDO case

Torresetti, Roberto and Pallavicini, Andrea (2007): Stressing rating criteria allowing for default clustering: the CPDO case. Unpublished.

Abstract

After a brief review of the literature on rating arbitrage for corporate and structured nance, we introduce the standard criteria adopted by rating agencies to assess riskiness of Constant Proportion Debt Obligations (CPDO). Then, we propose a new rating model in order to incorporate a more realistic loss distribution showing a multi-modal shape, which, in turn, is linked to default possibilities for clusters (possibly sectors) of names of the economy. In this framework, we show that the riskiness of CPDOs is substantially increased leading to a decrease of their rating, and in particular, we found that the expected payout of the gap-risk option, embedded in CPDOs, is greatly enhanced.

• Item Type: MPRA Paper
• Language: English
• Keywords: CPDO Rating, Rating Arbitrage, Structured Finance, Loss Distribution, Loss Dynamics, Cluster Default Dynamics, Gap Risk
• Subjects: G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing; Futures Pricing

References

Albanese, C., Chen, O., and D'Alessandro, A. (2005). Dynamic credit correlation modeling. Working paper available at http://defaultrisk.com/pp corr 80.htm

Altman, E.I., Kao, D.L. (1992) The implications of corporate bond ratings drift. Financial Analysts Journal, 48, 64-67.

Bangia, A., Diebold, F., Kronimus, A., Schagen, C., Schuermann, T. (2002) Ratings migration and the business cycle, with applications to credit portfolio stress testing. Journal of Banking and Finance 26, 445-474.

Brigo, D., Pallavicini, A. and Torresetti, R. (2007a) Calibration of CDO tranches with the dynamical Generalized-Poisson Loss model. Risk 5.

Brigo, D., Pallavicini, A. and Torresetti, R. (2007b) Cluster-based extension of the generalized Poisson loss dynamics and consistency with single names. IJTAF 10, 607.

Hull, J., and White, A. (2005). The perfect copula. Working paper available at http://www.rotman.utoronto.ca/~hull

Hull, J., Predescu, M. and White, A. (2005) Bond prices, default probabilities and risk premiums. Journal of Credit Risk, 1, 2, 53-60.

Lando, D., Skodeberg, T.M., (2002) Analyzing rating transitions and rating drift with continuous observations. Journal of Banking and Finance, 26, 423-444.

Lidnen A., Neugebauer, M, Bund, S., Schiavetta, J., Zelter, J., and Hardee, R. (2007) First generation CPDO: case study on performance and ratings. Working paper available at http://www.defaultrisk.com/pp crdrv119.htm

Longstaff, F.A. and Rajan, A. (2006) An empirical analysis of the pricing of collateralized debt obligations. Working paper available at http://www.defaultrisk.com/pp crdrv141.htm

Lucas, D., Lonski, J., (1992) Changes in corporate credit quality 1970-1990. Journal of Fixed Income, 1, 7-14.

Li, D.X., (2000) On Default Correlation: a Copula Approach. Journal of Fixed Income, 9, March, 43-54.

Nickell, P., Perraudin, W., Varotto, S., (2000) Stability of transition matrices. Journal of Banking and Finance, 24, 203-227.

Tejwani, G., Hamid, S., Varma, S., Jha, A., and Manappatil, H (2007) Rating criteria for CPDO structures. Fixed Income Research, Lehman Brothers.

Torresetti, R., Brigo, D., and Pallavicini, A. (2006a) Risk neutral versus objective loss distribution and CDO tranches valuation. Working paper available at http://ssrn.com/abstract=900784

Torresetti, R., Brigo, D., and Pallavicini, A. (2006b) Implied expected tranched loss surface from CDO data. Working paper available at http://ssrn.com/abstract=933291