Basics of Collateralized Debt Obligations (CDO)

(Basic) Multi-Name Credit Derivatives
Paola Mosconi
Banca IMI
Bocconi University, 14/03/2016
Paola Mosconi Lecture 6 1 / 69

Disclaimer
The opinion expressed here are solely those of the author and do not represent in
any way those of her employers

Main References
Brigo, D. and Mercurio, F. Interest Rate Models Theory and Practice. With
Smile, Inflation and Credit, Springer (2006)
Brigo, D. (2009), Essex Lecture Notes, Unit 5

Outline
1 Introduction
Securitization
Of Models and Mathematicians
2 Dependence
Credit Correlation
Dependence in Reduced Form Models
Copula Function
3 CDOs: Stylized Facts
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
One Factor Gaussian Copula
Large Homogeneous Portfolio (LHP)
5 Market Quotation Standard
Compound Correlation
Base Correlation
6 Selected References
Introduction
Outline
1 Introduction
Securitization
2 Dependence
Credit Correlation
Copula Function
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
Base Correlation
Introduction
Introduction
Multi-name credit derivatives are characterized by payoffs which depend on

more than one underlying reference entities.
A list of them includes:

First to default;
k-th to default, last to default;
CDS indices;
CDO tranches;
CDO squared tranches;
Leveraged Super Senior (LSS) CDO tranches
...

Introduction Securitization
Asset Backed Securities and Securitization
An asset-backed security (ABS) is a security whose income payments and hence

value is derived from and collateralized by a specified pool of underlying assets.
Securitization is the process of pooling together assets that would typically be

unable to be sold individually. It allows to sell them to general investors in the form
of tranches and to diversify the risk of investing.
Collateralized Debt Obligations CDOs are a particular kind of ABS, backed by

a diversified pool of debt obligations, e.g.
bonds (CBOs)
loans (CLOs)
CDS (synthetic CDOs)
other structured products

Short History of Securitization: up to the Crisis

(1997-2008)
In the period 1998 to 2007, the asset backed securities market increased expo-
nentially both in volume and diversity.
As the crisis unfolded in 2007/2008, such market came under substantial criticism
as some securitized products played a major role in the financial difficulties for
various reasons (see Prime Collateralized Securities):
badly underwritten products
opaqueness of structures
overleveraged issuances
...

Short History of Securitization: the Role of ECB (2014)
Despite the low issuance and the modest take-up by investors, most European structured
finance products performed well throughout the financial crisis from a credit standpoint,
with low realized default rates.
According to Standard & Poors, the cumulative default rate on European consumer
related securitizations, between the start of the financial downturn in July 2007 and Q3
2013 has been only 0.05%.
Discussion Paper by the European Central Bank and the Bank of England (July, 2014).
According to Mario Draghi (August 2014), asset-backed securities should be

simple, transparent and real, where:
simple means readable
transparent means that you can actually go through and price them well
real means that they are not going to be a sausage full of derivatives

Short History of Securitization: the Capital Market Union

(2015-2019)
On 2 December 2015, the Permanent Representatives Committee (Coreper) of the EU

approved a negotiating stance on proposals aimed at facilitating the development of a
securitisation market in Europe.
These proposals aim to relaunch the securitisation market, by promoting simple,

transparent and standardised (STS) securitisations. The objective is to con-
tribute to the financing of the economy and hence to the creation of jobs and
growth
Pierre Gramegna, minister of finance of Luxembourg and president of the Council.
A framework for securitisation is the first major building block of the EUs plan, launched
during 2015, to develop a fully functioning capital markets union by the end of 2019.
Developing a securitisation market will help create new investment possibilities and provide
an additional source of finance, particularly for SMEs and start-ups.

Short History of Securitization: a Snapshot
Figure: European securitization outstanding (left) and issuance (right). Source: BOE and
ECB (2014).

Introduction Of Models and Mathematicians
Recipe for disaster: the formula that killed Wall Street

(Wired Magazine, 2009)
Of couples and copula: the formula that felled Wall Street
(Financial Times, 2009)
Wall Streets math wizards forgot a few variables (New York Times, 2012)
Misplaced reliance on sophisticated math (The Turner Review, 2009)
vs
Did a mathematical formula really blow up Wall Street? (Embrechts, 2009)
Dont blame the quants (Shreve, 2008)
Crash Sonata in D Major (Szego, 2009)
Credit Models and the Crisis, or: How I learned to stop worrying and love the
CDOs (Brigo et al, 2010)

The Formula that Killed Wall Street (Wired 2009) I
Figure: Source: Recipe for Disaster: The Formula that Killed Wall Street. Wired
Magazine (2009).

The Formula that Killed Wall Street (Wired 2009) II
Undoubtedly, Lis formula has severe flows of which mathematicians and quants
were well aware even before the crisis.
The most dangerous partMr. Li himself says of the model, is when people
believe everything coming out of it. [...] Very few people understand the essence
of the model. [...] Its not the perfect model.But, he adds: Theres not a better
one yet.
To Stanfords Mr. Duffie, The question is, has the market adopted the model
wholesale in a way that has overreached its appropriate use? I think it has.
How a Formula Ignited Market That Burned Some Big Investors.

The Wall Street Journal, September 2005

...But, Arent We Missing Something?
1 Originate-to-distribute and trust in originators

2 Low interest rates
3 Increased risk appetite, excessive leverage
4 Real estate investments, and bubble
5 Equity extraction from residential properties
6 Managerial misbehavior, opaque investments and budgets
7 Systemically risky dimension
8 Adjustable rate mortgages
9 Regulatory errors
10 Herding and panic
Source: Szego, (2009)

The Heart of the Matter
CDOs tranches are difficult objects to price: tranching is a non-linear operation,

which requires the knowledge of the whole loss distribution of the pool of names.
Two ways:
1 The whole distribution is simulated (Monte Carlo)
2 Single name marginal distributions + dependence structure = copula
Where and how can we introduce dependence?

Dependence
Outline
1 Introduction
Securitization
2 Dependence
Credit Correlation
Copula Function
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
Base Correlation
Dependence Credit Correlation
Credit Correlation I
In literature different definitions of default correlation have been introduced

(see e.g. Li (2000), Hull and White (2000), Frey et al (2001)...).
Default Correlation
Given a time horizon T (typically one year) the default correlation between two
names can be expressed in terms of:
their marginal default probabilities q1 = E[1{1 <T } ] and q2 = E[1{2 <T } ]
their joint default probability q12 = E[1{1 <T } 1{2 <T } ]
as follows:
q12 q1 q2
12 = p
q1 (1 q1 )q2 (1 q2 )

Dependence Credit Correlation
Credit Correlation II
The above definition suffers from two problems:

The indicators being not elliptically distributed in general, correlation is not a
good measure of dependence
It is not possible to directly estimate historical correlation (not enough data on
joint defaults). As a proxy, asset correlation has been used instead but default
correlation is much lower than the corresponding asset correlation in all cases
Asset Correlation Default Correlation

10% 0.94%
20% 2.41%
30% 4.61%
Table: Asset correlation (estimated) vs. default correlation. Source: Frey et al (2001).

Dependence Dependence in Reduced Form Models
Single Name Framework
In the framework of reduced form (intensity) models, the default time is the first jump
of a Poisson process with intensity (t):
P( [t, t + dt)| t, market info up to t) = (t)dt ,
where is the intensity or hazard rate and represents an instantaneous credit spread.
Single name framework

Given that the cumulated intensity is distributed as an exponential random variable:
Z
( ) = (s)ds = exponential
0
the default time turns out to be:

= 1 ()

Multiple Name Framework I
Given multiple names, the dependence between default times
1 = 1 1 1
1 (1 ) , 2 = 2 (2 ) , . . . , n = n (n )
can be introduced in three ways:
1 put dependence in (stochastic) intensities of the different names and keep the of
different names independent
2 put dependence among the of different names and keep the intensities (either
stochastic or deterministic) independent. This is the approach currently used for
correlation products in the market
3 put dependence both among the and the intensities of different names

Multiple Name Framework II

Dependence Copula Function
Introduction to Copula Function I
Linear correlation is not enough to express the dependence between two random variables.
Example: Correlation between X N (0, 1) and Y = X 3

X and Y have the same information content and should have maximum dependence, but
r
E[X 4 ] E[X 3 ]E[X ] 3 3
= = < 1!
Std(X 3 )X 15 5
Correlation works well only for Gaussian variables!
In credit derivatives with intensity models, dependence must be introduced in the expo-
nential components of the Poisson processes for different names.
This is usually done by means of Copula functions.

Introduction to Copula Function II
Definition
Let (U1 , . . . , Un ) be a random vector with uniform margins and joint distribution
C (u1 , . . . , un ). C (u1 , . . . , un ) is the copula of the random vector.
Sklars Theorem
Let H be an n-dimensional distribution function with margins F1 , . . . , Fn . Then, there exists
an n-copula C (i.e. a joint distribution function on n uniforms) such that for all x Rn
H(x1 . . . , xn ) = C (F1 (x1 ), . . . , Fn (xn )) .
Any joint distribution function can be used to define a copula:
C (u1 , . . . , un ) = H(F11 (u1 ), . . . , Fn1 (un ))

Gaussian Copula
The Gaussian (or Normal) copula plays a central role in the modeling of credit dependence.
Gaussian Copula
It is obtained by using a multivariate normal distribution NRn with standard Gaussian
margins and correlation matrix R as multivariate distribution H:
CN (R) (u1 , . . . , un ) = NRn (N 1 (u1 ), . . . , N 1 (un )) (1)

1
where N is the inverse of the standard normal cumulative distribution.
Notice that this formula entails a n-dimensional integral!
Properties
No closed form expression, except for n = 2.
For n names, the correlation matrix R has n(n 1)/2 free parameters.
No tail dependence (upper/lower).
C (u, v ) = C (v , u) i.e. exchangeable copula.

Gaussian Copula Simulation: Uniform R.V.
Given a random variable X , its transformation through its cumulative distribution

function FX (X ) produces a uniform random variable U:
FU (u) = P(U u) = P(FX (X ) u) = P(X FX1 (u)) = FX (FX1 (u)) = u
The property FU (u) = u is characteristic of a standard uniform distribution U(0, 1).
The random variable = ( ) exp(1) can be expressed in terms of a uniform

random variable U U(0, 1) as follows:
F () = 1 e = U = = ln(1 U)
Goal
Model dependence across default times 1 , . . . , n , by introducing dependence directly
among standard uniforms!

Gaussian Copula Simulation

Uniform simulation
1 Find the Cholesky decomposition A of the correlation matrix R, such that R = AAT
2 Simulate n independent random variables Z1 , . . . , Zn from N (0, 1)
3 Set X = AZ
4 Set Ui = N(Xi ), i = 1, . . . , n
5 (U1 , . . . , Un ) CN (R)
Default times simulation

1 Simulate (or calibrate to CDS market quotes) individual intensities i (in the
simplest case, are independent and deterministic)
2 Simulate n uniforms according to the above copula procedure
3 Set different names default times according to:
1 = 1 1
1 ( ln(1 U1 )), . . . , n = n ( ln(1 Un ))
The dependency among the is loaded into a copula function on the U.

Example Reloaded
Dependence between X N (0, 1) and Y = X 3

X and Y have the same information content. By using the copula function we show that
they have maximum dependence, i.e.
P(U1 u1 , U2 u2 ) = min(u1 , u2 )
where U1 = FX (x) and U2 = FY (y ).
Consider that:
U2 = FY (y ) = FX 3 (x 3 ) = P(X 3 x 3 ) = P(X x) = FX (x) = U1
Therefore:
P(U1 u1 , U2 u2 ) = P(U1 u1 , U1 u2 ) = P(U1 min(u1 , u2 )) = min(u1 , u2 )
q.e.d.

CDOs: Stylized Facts
Outline
1 Introduction
Securitization
2 Dependence
Credit Correlation
Copula Function
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
Base Correlation
CDOs: Stylized Facts Stylized Facts
CDOs: The Portfolio Loss Distribution
CDOs are instruments related to the loss distribution of a pool of names.
The portfolio loss distribution is not symmetric but shows the following features:
skewed bell when the correlation is

low
monotonically decreasing when
correlation increases
Ushaped when correlation is close
to 1 (either all names survive or de-
fault)
Figure: Portfolio loss distribution.
Source: Lehman (2003).

(Synthetic) CDOs
Synthetic CDOs with maturity T are obtained by pooling together CDSs of different
names (up to n) with the same maturity and tranching the total loss:
n
X n
X
Loss(T ) = LGDi 1{i T } = (1 Reci ) 1{i T } (2)
i =1 i =1
along two attachment points A and B, with A < B. The protection seller pays the
protection buyer the cumulated tranched loss that exceeds A and does not exceed B.
Figure: Synthetic CDO.

CDOs: Tranched Loss
The (percentage) tranched loss between attachment points A and B at time t is given
by:
1
LosstrA,B (t) :=

(Loss(t) A)1{A<Loss(t)B} + (B A)1{Loss(t)>B}
B A
1
= (Loss(t) A)1{A<Loss(t)} (Loss(t) B)1{Loss(t)>B} (3)
B A
1
(Loss(t) A)+ (Loss(t) B)+

=
B A
or, in a compact notation:

0 if Loss(t) < A
Loss(t)A
LosstrA,B (t) = BA
if A < Loss(t) B
1 if Loss(t) > B


CDOs: Equity Tranche
The tranche [0, X ] absorbs the first losses up to X % of the total portfolio loss and it is
called equity tranche.
The corresponding tranched loss, according to (3) with A = 0 and B = X , is given by:
1
LosstrX (t) := Losstr0,X (t) = Loss(t) (Loss(t) X )+

X
It is useful to express any tranche [A, B] in terms of equity tranches, as follows:

1
LosstrA,B (t) = B LosstrB (t) A LosstrA (t)

(4)
B A

CDOs: Cash Flows
The contract consists of two legs: the default leg and the premium leg.
Schematically the cash flows of a CDOs contract can be summarized as follows:
Protection Prot. dLosstrA,B (t) at all t (T0 , Tb ] Protection

Seller rate R at Ta+1 , . . . , Tb on the outstanding notional Buyer
where:
dLosstrA,B (t) is the tranched loss increment at time t
the outstanding notional is given by the survived positive (re-scaled) notional at
the relevant payment time:
OutSttrA,B (t) = 1 LosstrA,B (t)

CDOs: Premium Leg
A,B
A premium rate R0,T (0) fixed at time T0 = 0 is paid at times T1 , . . . , Tb = T from the
protection buyer to the protection seller. The rate is paid on the survived positive notional
at the relevant payment time. This notional decreases of the same amount as the tranched
loss increases, taking into account the recovery.
Discounted premium leg payoff

X b Z Ti
A,B
PremLA,B (0) = D(0, Ti ) R0,T (0) OutSttrA,B (t)dt
i =1 Ti 1
b
X
A,B
R0,T (0) D(0, Ti ) i [1 LosstrA,B (Ti )]
i =1
where i = Ti Ti 1 .

CDOs: Default (Protection) Leg
Once enough names have defaulted and the loss has reached A, the counts start. Each
time the loss increases, the corresponding loss change re-scaled by the tranche thickness
B A (i.e. dLosstrA,B (t)) is paid to the protection buyer, until maturity arrives or until the
total pool loss exceeds B, in which case the payments stop.
Discounted default leg payoff
Z T b
X
ProtLA,B (0) = D(0, t)dLosstrA,B (t) D(0, Ti )[LosstrA,B (Ti ) LosstrA,B (Ti 1 )]
0 i =1

CDOs: Price of the Tranche
Assuming deterministic interest rates, the price of the tranche for the protection buyer
is:
TrancheA,B
0,T (0) = E[ProtLA,B (0)] E[PremLA,B (0)]
b
X
= P(0, Ti ) E[(LosstrA,B (Ti ) LosstrA,B (Ti 1 ))]
i =1 (5)
b
X
A,B
R0,T (0) P(0, Ti ) i [1 E(LosstrA,B (Ti ))]
i =1
where E[.] denotes the expectation under the risk neutral measure.
The premium rate that makes the contract fair at inception is therefore given by:
Pb tr tr
A,B i =1 P(0, Ti )[E[LossA,B (Ti )] E[LossA,B (Ti 1 )]]
R0,T (0) = Pb tr
(6)
i =1 P(0, Ti )i [1 E(LossA,B (Ti ))]

CDO Pricing
Outline
1 Introduction
Securitization
2 Dependence
Credit Correlation
Copula Function
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
Base Correlation
CDO Pricing
CDO Pricing
Goal
The problem of pricing a CDO tranche or calculating its premium rate consists in
calculating the corresponding expected tranched loss.
In the following we present two approaches:

the Monte Carlo method, which is more computational intensive
a semi-analytical approach based on two approximations: the Gaussian
Copula approach and the Large Homogeneous Portfolio approximation

CDO Pricing Monte Carlo Pricing
Monte Carlo Pricing
Pricing a CDO by means of Monte Carlo goes through the following steps:
1 Calibrate individual name intensities i from CDS market quotes.
2 Estimate the correlation matrix R.
3 Consider N scenarios and for each scenario j, simulate the dependent default
times through the copula approach outlined in slide 27.
4 At any given time t and for any scenario j, compute the loss and tranched loss
given respectively by eq. (2) and eq. (3).
5 Average across all scenarios in order to find the expected tranched loss
E[LosstrA,B (t)] at the desired date t or set of dates Ti .

CDO Pricing Monte Carlo Pricing
Monte Carlo Pricing: Limits and Alternative Methods
Monte Carlo pricing is conceptually straightforward, but has two main limitations:
1 An accurate estimate requires a large number of simulations and considering that

CDOs are composed of hundreds of names the process can be very time
consuming.
2 Estimation of the correlation matrix for n names involves n(n-1)/2 estimates of

pairwise correlations.
Semi-Analytical Methods
In order to overcome the limitations of the Monte Carlo approach, alternative methods
have been proposed, which rely on the semi-analytical computation of the portfolio
loss. One popular method combines:
the One Factor Gaussian Copula approach to calculate the joint default probability
the Large Homogeneous Portfolio (LHP) approach to calculate the portfolio loss

CDO Pricing One Factor Gaussian Copula
One Factor Gaussian Copula: Introduction
A one factor copula model is a way of modeling the joint defaults of n different
names.
The structure for this model was suggested by Vasicek (1987) and it was first
implemented by Li (2000) and Gregory and Laurent (2005).
Idea
One Factor Gaussian Copula reduces the dimensionality of the problem,
increasing analytical tractability. For this reason, it has become a standard when
pricing CDOs and CDS Index tranches.

One Factor Gaussian Copula I
The One Factor Gaussian Copula approach goes through the following steps:
1 We consider n names and start from their default times, to which the copula will be
applied:
1 = 1 1
1 ( ln(1 U1 )), . . . , n = n ( ln(1 Un ))
2 We rewrite the definition of copula given by eq. (1) under the risk neutral measure
Q:
C (u1 , . . . , un ) = NRn (N 1 (u1 ), . . . , N 1 (un ))
(7)
= Q(X1 < N 1 (u1 ), . . . , Xn < N 1 (un ))
This entails the calculation of a n-dimensional integral!

One Factor Gaussian Copula II
3 Inspired by the works of Merton (1974) and Vasicek (1987), we set Ui = N(Xi ),
where the standard Gaussian variables Xi are expressed in terms of:
a systematic common factor Y N (0, 1)
a idiosyncratic term, specific to each name, i N (0, 1) and i.i.d.
p
Xi = i Y + 1 i i (8)

such that corr(Xi , Xj ) = i j
Here, a first simplification occurs: the original number of free correlation

parameters is reduced from n(n 1)/2 to n!

One Factor Gaussian Copula III
4 Applying the law of iterated expectations to eq. (7), by conditioning on Y , we

obtain:
h i
C (u1 , . . . , un ) = E Q(X1 < N 1 (u1 ), . . . , Xn < N 1 (un )|Y ) (9)
5 Conditional on Y = y , the variables Xi are independent and the joint probability

Q(.|Y ) can be written as the product of the following single name probabilities:

Q(Xi < N 1 (ui )|Y = y ) = Q( i Y + 1 i i < N 1 (ui )|Y = y )
p
!
N 1 (ui ) i y (10)
=N
1 i

One Factor Gaussian Copula: Results
Substituting the single name probabilities (10) into eq. (9), the Gaussian Copula
C (u1 , . . . , un ), in the One Factor framework, can be expressed as one-dimensional
integral:
Z "Y n !#
N 1 (ui ) i y
C (u1 , . . . , un ) = N (y )dy (11)
i =1
1 i
where (y ) is the standard Gaussian probability density.
Dimensionality Reduction
Original Problem One Factor Gaussian Copula

integral dimension n 1
free correlation parameters n(n 1)/2 n

One Factor Gaussian Copula: Deterministic Intensity
Under the assumption of deterministic intensities:
Q(i < T |Y = y ) = Q(i (i ) < i (T )|Y = y ) = Q(i < i (T )|Y = y )

!
i (T ) N 1 (1 e i (T ) ) i y
= Q(Ui < 1 e |Y = y ) = N
1 i
(12)
the (unconditional) joint default probability of n names becomes:

Z "Y n !#
N 1 (1 e i (T ) ) i y
Q(1 < T , . . . , n < T ) = N (y )dy (13)
i =1
1 i
Remark The market further reduces the dimensionality of the problem by introducing a
single value of correlation i = for quotation reasons.

CDO Pricing Large Homogeneous Portfolio (LHP)
LHP: Goal and Assumptions
Goal
The Large Homogeneous Portfolio (LHP) approach allows to derive closed form
expressions for the (expected) portfolio loss, Loss, and the (expected) tranched loss,
LosstrA,B .
Assumptions:
1 Gaussian Copula
2 homogeneity of the characteristics of names underlying the credit portfolio:
Notionali = Notional, Reci = Rec, i = , i =
3 large number n of names (above 100)

LHP: Homogeneity I
Homogeneity in recovery rates, default probabilities and correlations implies that:
1 the probability of a single default in the portfolio, conditional on the systematic

factor Y , as given by eq. (12) in the Gaussian Copula framework, is independent of
the defaulting name i and therefore unique:
!
N 1 (p) y
Q(i < T |Y = y ) = N
1
where p = 1 e (T ) is the unconditional probability of default.
2 Exploiting independence of single names, conditionally on Y , and the common

value of the default probability across names, the conditional probability of having
k defaults among the n obligors is:

n
Q(k defaults|Y = y ) = Q( < T |Y = y )k [1 Q( < T |Y = y )]nk (14)
k

LHP: Homogeneity II
3 The unconditional probability of having k defaults among the n obligors is ob-

tained from eq. (14), by integrating on the common risk factor:
Z +
Q(k defaults) = Q(k defaults|Y = y ) (y )dy (15)

In general, this integral has to be computed numerically. This is the reason why this
kind of approach is called semi-analytical.
4 In the homogeneous portfolio framework, under the assumption of constant recovery

rate Reci = Rec, the probability of having a portfolio loss
K = k (1 Rec)
caused by the default of k names is equal to the probability of having k defaults:
Q(Loss = K ) = Q(k defaults)

LHP: Large Pool Model (JP Morgan) I
McGinty and Ahluwalia (2004) have exploited the third assumption of the LHP approach,
i.e. the infinite size of the portfolio.
We introduce the default rate (DR) of the pool, at a given time T , as the fraction of
defaulted names w.r.t. the total pool of names. Conditional on the systematic factor Y it
is given by:
n
1X
DRnT (Y ) = 1{i T |Y }
n i =1
Conditional on Y , defaults are i.i.d. variables with mean given by the conditional proba-
bility of default:
!
N 1 (p) y
p(Y ; ) := E[1{i T |Y =y} ] = Q{i T |Y =y} = N .
1

LHP: Large Pool Model (JP Morgan) II
Law of Large Numbers

By applying the Law of Large Numbers, the default rate DR, tends to:
DRnT (Y ) p(Y ; )
n
and the conditional percentage loss turns out to be:
Loss
T (Y ; ) = (1 Rec) p(Y ; ) (16)

LHP: Tranched Loss I
GOAL: To derive a closed form expression for expected tranched losses
Consider an equity tranche with attachment points [0, X ].

1 Conditional on Y , using the large pool results, the expected tranched loss
coincides with the tranched loss:
1
E[Losstr, tr,
0,X (Y ; )] = Loss0,X (Y ; ) := min(Loss
T (Y ; ), X )
X
2 The unconditional (expected) tranched loss is obtained by integrating over the

common risk factor Y :
Z
1
E[Losstr, tr,
0,X ()] = Loss0,X () = min(Loss T (Y = y ; ), X ) (y )dy (17)
X

LHP: Tranched Loss II
Expected Equity Tranche Loss

The integral (17) admits a closed form solution, yielding the expected Equity Tranche
loss:
LGD
Losstr,
0,X () = N(D) + N2 D, N 1 (p), (18)
X
(T )
where p = 1 e ,

1 X
D := N 1 (p) 1 N 1
p
LGD
and N2 (., ., r ) is the standard normal cumulative distribution function with correlation r .
(Expected) tranched losses associated to generic tranches with attachment points

[A, B] are retrieved through eq.s (18) and:
1
Losstr, B Losstr, tr,
A,B () = 0,B () A Loss0,A () (19)
B A

Market Quotation Standard
Outline
1 Introduction
Securitization
2 Dependence
Credit Correlation
Copula Function
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
Base Correlation
Market Quotes
Markets quote CDO tranches only for standardized pools of CDS on different names.
The most liquid indices are the DJi-TRAXX, involving 125 European names and the
DJCDX, involving 125 US names.
A,B
Premium rates R0,T (0) are quoted for the maturities
T = 3y , 5y , 7y , 10y
and standard attachment points
[0%, 3%] , [3%, 6%] , [6%, 9%] , [9%, 12%] , [12%, 22%] for DJi-TRAXX
and
[0%, 3%] , [3%, 7%] , [7%, 10%] , [10%, 15%] , [15%, 30%] for DJCDX

Implied Correlation
From premium rate quotes, it is market practice to derive the default correlation, which
goes by the name of implied correlation.
Usually implied correlation is retrieved by assuming:

a Gaussian Copula model (standard or One Factor), and deterministic spreads,
for the pricing
a unique correlation parameter, which does not diversify across country, sector etc.
Implied Correlation
Two types of correlation are adopted by the market:
1 compound correlation
2 base correlation

Bootstrapping Implied Correlation
The bootstrapping procedure for a given maturity T and tranche [A, B] goes through the
following steps:
1 The equation used to bootstrap is given by (6), that we recall here:
Pb mkt
i =1 P (0, Ti )[E[LosstrA,B (Ti )] E[LosstrA,B (Ti 1 )]]
R AB,mkt = Pb mkt (0, T ) [1 E(Losstr (T ))]
i =1 P i i A,B i
2 under the Gaussian Copula assumption (e.g. in the LHP approximation) the
expected tranche loss is given by eq.s (19) and (18), i.e.:
1
E(LosstrA,B ) = Losstr, B Losstr, tr,

A,B = 0,B () A Loss0,A ()
B A
LGD
E(Losstr0,X ) = Losstr,
0,X () = N(D) + N2 D, N 1 (p), := f0X
GC
()
X

Market Quotation Standard Compound Correlation
Compound Correlation I
Compound correlation is based on the assumption that each tranche [A, B] is

characterized by a unique value of correlation AB .
Therefore, we solve recursively eq. (6), where the expected losses are given by:
[0, A] : E(Losstr0,A ) = f0A

GC
(0A )
tr 1 GC GC

[A, B] : E(LossA,B ) = B f0B (AB ) A f0A (AB )
B A
(20)
tr 1 GC GC

[B, C ] : E(LossB,C ) = C f0C (BC ) B f0B (BC )
C B
...
Typically, the compound correlation structure presents a smile.

Compound Correlation II
Figure: Example of compound correlation for the DJ-iTraxx. Source: Brigo and Mercurio
(2006).

Compound Correlation III
The smile behavior of the compound correlation can be explained as follows:
Senior Tranches: high attachment points are reached when many defaults occur, i.e.
when default correlation is large (similar to historical correlation)
Mezzanine Tranches: spreads are low given the high demand for these tranches (this
implies low correlation)
Equity Tranche: large spreads are obtained from low correlation. This tranche is
impacted by every default and a large correlation would mean a low probability of a
single default (lower than historical correlation)

Compound Correlation: Non Invertibility I

However, for some values of the market premia, it is not guaranteed that all the
bootstrapping equations (20) yield a solution. In that case, the compound correla-
tion is non-invertible.
Figure: DJ-iTraxx 10 year compound correlation invertibility. Tranche Market spread

(solid line) versus theoretical tranche spread obtained varying the compound correlation
between 0 and 1 (dotted black line). Source: Brigo et al (2010).

Compound Correlation: Non Invertibility II
Figure: Compound correlation invertibility indicator (1=invertible, 0=not invertible) for

the DJ-iTraxx and CDX tranches. Source: Torresetti et al (2006).

Market Quotation Standard Base Correlation
Base Correlation I
Base correlation is based on the assumption that each equity tranche [0, X ] is
characterized by a unique value of correlation 0X , implying that a tranche [A, B]
depends on two values of base correlation.
Therefore, we solve recursively eq. (6), where the expected losses are given by:
[0, A] : E(Losstr0,A ) = f0A

GC
(0A )
1 GC
[A, B] : E(LosstrA,B ) = GC
B f0B (0B ) A f0A (0A )
B A
tr 1 GC GC

[B, C ] : E(LossB,C ) = C f0C (0C ) B f0B (0B )
C B
...
Typically, the base correlation structure presents a skew.

Base Correlation II
Figure: Example of base correlation for the DJ-iTraxx. Source: Brigo and Mercurio
(2006).

Compound Correlation vs Base Correlation
If the Gaussian Copula assumptions were consistent with market tranche prices, there
would be a unique Gaussian Copula model (i.e. unique correlation) consistent with the
market and no distinction between compound correlation and base correlation.
Compound Correlation: Base Correlation:

More consistent at the level of Inconsistent at the level of single
single tranche (one single copula tranche (different parts of the same
model). payoff with different models).
Depends on pairs of attachment Depends on a single attachment
points. point.
Cannot be easily interpolated Easy to interpolate/extrapolate.
and/or extrapolated. Able to price non standard tranches.
Unable to price non standard (so Can be always retrieved, but may
called bespoke) tranches. yield negative expected tranched
May not exist. losses (very steep skew).

Selected References
Outline
1 Introduction
Securitization
2 Dependence
Credit Correlation
Copula Function
Stylized Facts
4 CDO Pricing
Monte Carlo Pricing
Base Correlation
Selected References
Selected References I
Bank of England and European Central Bank (2014), The Case of a Better
Functioning Securitisation Market in the European Union, Discussion Paper
Brigo, D., Pallavicini, A., and Torresetti, R. (2010). Credit Models and the Crisis, or:
How I learned to stop worrying and love the CDOs. Credit Models and the Crisis: A
journey into CDOs, Copulas, Correlations and Dynamic Models, Wiley, Chichester.
Frey, R., McNeil, A.J., and Nyfeler, M.A. (2001): Modeling Dependent Defaults:
Asset Correlations Are Not Enough!.
http://www.risklab.ch/ftp/papers/FreyMcNeilNyfeler.pdf
Laurent, J.P., and Gregory, J., (2005). Basket Default Swaps, CDOs and Factor
Copulas. Journal of Risk, Vol. 7, No. 4, 103-122
Hull, J., and White, A. (2000). Valuing Credit Default Swaps II: Modeling Default
Correlations, Journal of Derivatives, Vol. 8, No. 3
The Lehman Brothers Guide to Exotic Credit Derivatives (2003)

Selected References
Selected References II
Li, D. X., (2000), On Default Correlation: A Copula Approach, Journal of Fixed

Income, 9
Merton, R. (1974), On the pricing of corporate debt: The risk structure of interest
rates. J. of Finance 29, 449-470
McGinty, L., Ahluwalia, R., (2004). A Model for Base Correlation Calculation, JPM
technical document
Prime Collateralised Securities, http://pcsmarket.org/
Szego, G. (2010). Crash 08: a regulatory debacle to be mended, Special Paper 189,
LSE Financial Markets Group Paper Series
Torresetti, R., Brigo, D., and Pallavicini, A. (2006). Implied correlation in CDO
tranches: a Paradigm to be handled with care. Available on ssrn
Vasicek, O. (1987). Probability of loss on a loan portfolio. Working Paper, KMV
Corporation

Basics of Collateralized Debt Obligations (CDO)

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Basics of Collateralized Debt Obligations (CDO)

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(Basic) Multi-Name Credit Derivatives

Bocconi University, 14/03/2016

Paola Mosconi Lecture 6 1 / 69

Paola Mosconi Lecture 6 2 / 69

Paola Mosconi Lecture 6 3 / 69

Multi-name credit derivatives are characterized by payoffs which depend on

A list of them includes:

Paola Mosconi Lecture 6 6 / 69

Asset Backed Securities and Securitization

An asset-backed security (ABS) is a security whose income payments and hence

Securitization is the process of pooling together assets that would typically be

Collateralized Debt Obligations CDOs are a particular kind of ABS, backed by

Paola Mosconi Lecture 6 7 / 69

Short History of Securitization: up to the Crisis

Paola Mosconi Lecture 6 8 / 69

Short History of Securitization: the Role of ECB (2014)

According to Mario Draghi (August 2014), asset-backed securities should be

Paola Mosconi Lecture 6 9 / 69

Short History of Securitization: the Capital Market Union

On 2 December 2015, the Permanent Representatives Committee (Coreper) of the EU

These proposals aim to relaunch the securitisation market, by promoting simple,

Paola Mosconi Lecture 6 10 / 69

Short History of Securitization: a Snapshot

Paola Mosconi Lecture 6 11 / 69

Of Models and Mathematicians

Recipe for disaster: the formula that killed Wall Street

Paola Mosconi Lecture 6 12 / 69

The Formula that Killed Wall Street (Wired 2009) I

Paola Mosconi Lecture 6 13 / 69

The Formula that Killed Wall Street (Wired 2009) II

How a Formula Ignited Market That Burned Some Big Investors.

Paola Mosconi Lecture 6 14 / 69

...But, Arent We Missing Something?

1 Originate-to-distribute and trust in originators

Source: Szego, (2009)

Paola Mosconi Lecture 6 15 / 69

The Heart of the Matter

CDOs tranches are difficult objects to price: tranching is a non-linear operation,

Where and how can we introduce dependence?

Paola Mosconi Lecture 6 16 / 69

In literature different definitions of default correlation have been introduced

Paola Mosconi Lecture 6 18 / 69

The above definition suffers from two problems:

Asset Correlation Default Correlation

Paola Mosconi Lecture 6 19 / 69

Single Name Framework

P( [t, t + dt)| t, market info up to t) = (t)dt ,

Single name framework

the default time turns out to be:

Paola Mosconi Lecture 6 20 / 69

Multiple Name Framework I

Given multiple names, the dependence between default times

can be introduced in three ways:

Paola Mosconi Lecture 6 21 / 69

Multiple Name Framework II

Paola Mosconi Lecture 6 22 / 69

Introduction to Copula Function I

Example: Correlation between X N (0, 1) and Y = X 3

Correlation works well only for Gaussian variables!

Paola Mosconi Lecture 6 23 / 69

Introduction to Copula Function II

H(x1 . . . , xn ) = C (F1 (x1 ), . . . , Fn (xn )) .

Any joint distribution function can be used to define a copula:

C (u1 , . . . , un ) = H(F11 (u1 ), . . . , Fn1 (un ))