Correlation - the hidden risk in Collateralized Debt Obligations

by Richard K. Skora of Skora & Company Inc.

November 21, 1998

Beginning Paragraphs: Collateralized Debt Obligations are one of the most interesting innovations of the securitization market in the 90's. They create new, customized asset classes by allowing various investors to share the risk and return of an underlying pool of debt obligations. The attractiveness to investors is determined exactly by the underlying debt and the rules for sharing the risk and return.

A Collateralized Debt Obligation is a correlation product. Investors in this product are buying correlation risk. To determine that they are getting a fair return for this risk, they must be able to measure the correlation risk.

Since the 1950's when Markowitz did his pioneering work on portfolio theory ¹ , there has been intense study of correlation between equity investments. Equities are liquid and have relatively small transactions cost - lending themselves well to portfolio re-balancing.

Correlation between debt securities has not been studied so intensely - possibly because debt securities other than US Treasuries are not liquid and have high transactions cost.

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¹ Markowitz, Harry, Portfolio Selection, Journal of Finance, March 1952, pp. 77-91.