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Stressing Rating Criteria Allowing for Default Clustering: The CPDO case

by Roberto Torresetti of Banco Bilbao Vizcaya Argentaria, and
Andrea Pallavicini of Banca Leonardo

September 4, 2009

Abstract: After a brief review of the literature on rating arbitrage for corporate and structured finance, we introduce the standard criteria adopted by rating agencies to assess riskiness of Constant Proportion Debt Obligations (CPDO). Then, we propose a new rating model in order to incorporate a more realistic loss distribution showing a multi-modal shape, which, in turn, is linked to default possibilities for clusters (possibly sectors) of names of the economy. In this framework, we show that the riskiness of CPDOs is substantially increased leading to a decrease of their rating, and in particular, we found that the expected payout of the gap-risk option, embedded in CPDOs, is greatly enhanced.

JEL Classification: G13.

AMS Classification: 60J75, 91B70.

Keywords: CPDO Rating, Rating Arbitrage, Structured Finance, Loss Distribution, Loss Dynamics, Cluster Default Dynamics, Gap Risk.

This paper is Published as Ch. 20 in...

Credit Risk Frontiers: Subprime Crisis, Pricing and Hedging, CVA, MBS, Ratings, and Liquidity

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