Forwards and European Options on CDO Tranches

by John Hull of the University of Toronto, and
Alan White of the University of Toronto

March 2007

Abstract: Now that the market for cash and synthetic CDOs is well established, there is increased interest in trading forward contracts and options on CDO tranches. This article develops models for valuing these instruments. The model for valuing European options on CDO tranches has similarities to the standard market model for valuing European swap options and to the model for valuing options on credit default swaps. Once default probabilities, the expected recovery rates and the degree to which defaults tend to cluster have been estimated, it enables traders to calculate option prices from CDO tranche swap spread volatilities and vice versa.

Keywords: CDO, Forward, Option.

Published in: Journal of Credit Risk, Vol. 3, No. 2, (Summer 2007), pp. 63-73.

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