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THEEDGE mal aysia | june 7, 2010

Pricing of a CDO

rom the previous article, we begin to appreciate the complexity of the CDO. However, its most complex aspect by far would be its pricing.A CDO is constructed with a pool of securities, 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.

**by Jasvin Josen
**

main reason for its wide usage is its ease of implementation and calibration.

Chart 1: Copulas to generate correlated default times

Independent uniform random numbers Transform uniform into normal numbers then impose correlation 12

1

CDO pricing steps

CDO models

While the first CDOs were issued as early as 1987, they emerged in the securities 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 models using calibrated parameters. Copulas are one of the methodologies that first caught the attention of most market practitioners to model the dependency structure in the asset portfolios. Despite its drawbacks, the

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 Gaussian 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

12

12

0 1

Translated survival rate into default probabilities using individual default curve 1

12 Map the correlated normals back to uniform numbers, representeing correlated survival rates 1 0.6

0.6

0

6-yr

Default time for Asset 1 time

0

1

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 Standardised index CDOs in the mar- time and constant across assets. estimated to default only between 7 to ket like the CDX and iTraxx have quot20 years,then the tranches have low risk ed bid and offer prices. The tranche (ii) mOdel the dependent default and would command low spreads. prices are put in the Gaussian Copula times The objective of the Gaussian Copula 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 exists between the assets in the pool, hence one asset’s default could be dependent 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 numbers 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 depiction is illustrated in Chart 1.

iii) cOmpute the pOOl el

loss is $62 million; this means that the equity and 10-25% tranches are fully wiped out. In simulation 3, only Asset 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 = A = Rec = Det = Att = the tranche Pool EL recovery rate notional at detachment point (in this case $25m) notional at attachment point (in this case $10m)

In Chart 2,say we have a two-asset portfolio example. Assume that the default 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 assets 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 [df (t) ∗ (TranchEL(t)−TrancheEL(t−1))] 0 distribution discussed in my previous article. PVfee leg =

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 contingent 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 using the formulae given:

v) price the cdO tranche

∫

Let us look at a CDO with a total notional 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

iv) cOmpute the tranche el

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-

CDO MODels: Opening the BlaCk BOx, DresDner kleinwOrt, OCtOBer 2008

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THEEDGE mal aysia | june 7, 2010

41

Chart 2: Computation of Pool and Tranche eL

Simulations 1 2 3 A Estimated Default time Asset 1 Asset 2 6 yr 4.5 yr 3 yr 10 yr 2 yr 8 yr B Default time less than maturity of 5 yrs? NO YES (both) YES (Asset 1) C Pool EL ($m) (before discounting)

Note 1

Chart 3

D 10-25% Tranche EL (before discounting) ($m) 0 25 4

Total Notional= $100m

0 62 14

25%

15m

10%

10,000

Note 1

10m

0%

Asset 1: Asset 2:

Notional $ (m) 20 80 100 20 80 100

Recovery Loss rate 0.3 20 (1-0.3) = 14 0.4 80 (1-0.4) = 48 62 0.3 20 (1-0.3) = 14 14

Asset 1: Asset 2:

riod,the notional is evaluated to see if it has decayed when defaults occurred.As for the contingent leg,the PV is simply the EL of the tranche that the PS has to make good to the PB upon default.The calculation takes place in a continuous time period (and not discrete) thus the use of integration in the formulae.

The Abacus case

If we go back to the Abacus’s case, Goldman wrote down its unhedged 45%-50% portion about a week after the transaction was completed. Going back to the above valuation principles, it must be the case where the steep individual default curves of the sub-

prime loans coupled with high correlation led to very near default times in the model. Events have shown that correlation tends to get stronger as asset quality worsens. This triggered massive pool EL which ate through the 45-50% tranche very quickly.As GS was the protection

seller, the value of the CDO tranche in its books would be + PV (premium leg) – PV (contingent leg). The high negative PV of the contingent leg pushed down the tranche’s mark-tomarket value. It is a wonder how the 50-100% tranche of the same CDOs was valued in ACA Capital’s books,considering that it willingly entered into such a deal. Besides admitting to the cumbersome process involved in pricing a CDO, the above points out that the main driver of CDO valuation is how dependent the defaults are in the reference portfolios. This in turn depends on the steepness of default curves (credit quality) and correlation among the assets.

The Abacus event was tragic but at least it has taught us some interesting technical aspects.We acknowledge how funded transactions are crucial in minimising counterparty risk.One can also appreciate the significance of loss distributions in figuring out how risky a CDO is.We also have come to terms with pricing of a CDO to recognise how the main drivers, defaults and correlation act together to impact its value. After the financial crisis,many practitioners realised how far off their pricing models were,when values of CDOs plunged in the market. One of the issues was that the correlation skew, the difference between the modelled and market correlation (just like the volatility smile in the Black Scholes world) was not captured properly. More focus is being given to other copulas that capture better tail risk (or remote events) and dynamic models with dynamic correlation surface to produce better models.After an eventful decade of a rise and a fall, hopefully the CDO will now mature into an instrument with robust pricing and risk management. Jasvin Josen is a specialist in developing methodologies for the valuation of various credit products. She has over 10 years’ experience in investment banking and the financial industry in Europe and Asia. Comments: jasvin@gmail.com.

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The complicated CDO pricing explained in a step by step process

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