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How has CDO Market Pricing Changed During the Turmoil: Evidence from CDS index tranches

by Martin Scheicher of the European Central Bank

June 2008

Abstract: This paper applies regression analysis to investigate the fundamental factors of the variation of CDS index tranches. The sample comprises daily data on the tranche premia of the European iTraxx and North American CDX index from the start of the market in summer 2004 to January 2008. I estimate the relationship between tranche premia and market-based measures of credit risk, liquidity risk and interest rate risk. In this context, I analyse how the set of explanatory factors has changed since the start of the credit market turmoil in 2007. Overall, I find that pricing of CDX and iTraxx tranches differs although the specifications of the two contracts are very similar. Since July 2007, tranche investors appear to have repriced CDX contracts to a larger extent than iTraxx contracts. Credit risk and liquidity factors are priced in almost all tranches with liquidity risk playing a larger role since the start of the turmoil.

JEL Classification: E43, G12, G13, G14.

Keywords: Credit Spread, Credit derivative, Collateralised Debt Obligation, Correlation.

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