Pricing CDOs with State Dependent Stochastic Recovery Rates
by Salah Amraoui of BNP Paribas,
September, 9, 2009
Abstract: Up to the 2007 crisis, research within bottom-up CDO models mainly concentrated on the dependence between defaults. However, due to the substantial increase in the market price of systemic credit risk protection, more attention has been paid to recovery rate assumptions. In this paper, we focus first on deterministic recovery rates in a factor copula framework. We use stochastic orders theory to assess the impact of a recovery markdown on CDOs and show that it leads to an increase of the expected loss on senior tranches, even though the expected loss on the portfolio is kept fixed. This result applies to a wide range of latent factor models. We then suggest introducing stochastic recovery rates in such a way that the conditional on the factor expected loss (or equivalently the large portfolio approximation) is the same as in the recovery markdown case. However, granular portfolios behave differently. We show that a markdown is associated with riskier portfolios that when using the stochastic recovery rate framework. As a consequence, the expected loss on a senior tranche is larger in the former case, whatever the attachment point.
Keywords: credit risk assessment, recovery rates, CDOs, stochastic orders.