The Impossible Trio in CDO Modeling
by Emmanuel Schertzer of the Barclays Capital,
November 30, 2010
Abstract: We show that stochastic recovery always leads to counter-intuitive behaviors in the risk measures of a CDO tranche - namely, continuity on default and positive credit spread risk cannot be ensured simultaneously. We then propose a simple recovery variance regularization method to control the magnitude of negative credit spread risk while preserving the continuity on default.
Keywords: CDO, stochastic recovery, continuity on default