Credit Risk Modeling Using Excel and VBA with DVD

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Risk Analysis and Pricing of Structured Credit: CDOs and First-to-Default Swaps

In structured credit transactions, pay-offs depend on the default performance within a portfolio. In a first-to-default swap, for example, a payment is made upon the first default that happens within a group of issuers. Collateralized debt obligations (CDOs) are claims on a debt portfolio that differ in their seniority. A CDO is only affected if the portfolio loss exceeds some threshold level: the more senior the obligation, the higher the threshold level.

In this chapter, we clarify the basic concepts and methods for analyzing structured credit transactions. We first show how to determine the risk structure of CDOs both by simulation and analytically. For the latter we rely partly on the large homogenous portfolio (LHP) approximation, in which the CDO portfolio is proxied by a portfolio with an infinite number of loans that are uniform in their risk parameters. Then we simulate correlated default times over several periods. In each step, we make heavy use of concepts from Chapter 6 and of simulation tools developed in Chapter 7.

Finally, we create pricing routines for CDOs. We show how to use the LHP approximation for the pricing of multi-period CDOs, and then we develop a simulation-based pricing routine.

ESTIMATING CDO RISK WITH MONTE CARLO SIMULATION

Consider a portfolio with N loans that mature in one year with exposure totaling 100. Now issue three obligations: the most senior obligation has ...