Pricing and Hedging CLOs with Implied Factor Models

by Jovan Nedeljkovic of R ² Financial Technologies,
Dan Rosen of R ² Financial Technologies & the Fields Institute, and
David Saunders of the University of Waterloo

June 15, 2009

Abstract: The current financial crisis has underscored the need for transparent and robust methods for valuing and hedging structured credit portfolios. First-generation models, such as the Gaussian copula-based methods have well documented practical and theoretical limitations. In this paper, we demonstrate the practical application of the weighted Monte Carlo methodology to value and compute sensitivities and risk statistics for CLO portfolios and CLO-squared structures. The model extends the full bottom-up approach of Rosen and Saunders (2009) for pricing bespoke CDOs to include cancellability and stochastic LGDs in a natural way. The performance of the model is analyzed throughout a three‐month period during the credit crisis in 2008. The model calibrates very well to observed prices for the CDXHY and LCDX indices, and provides stable implied distributions for the systematic factor. Furthermore, it gives robust, consistent prices and sensitivities for CLOs and CLO-squared transactions, even during this very volatile period.

JEL Classification: G13.

Keywords: CLO, CDO valuation, bespoke CDO, structured credit, implied factor model.

Published in: Journal of Credit Risk, Vol. 6, No. 3, (Fall 2010), pp. 53-97.

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