An Empirical Analysis of the Pricing of Collateralized Debt Obligations

by Francis A. Longstaff of the University of California, Los Angeles, and
Arvind Rajan of Citigroup

January 2007

Abstract: We use the information in collateralized debt obligation (CDO) prices to study market expectations about how corporate defaults cluster or are correlated across firms. We find that a three-factor portfolio credit model allowing for firm specific, industry, and economy wide default events explains virtually all of the time series and cross-sectional variation in an extensive data set of CDX index tranche prices. These tranches are priced as if losses of 0.4, 6, and 35 percent of the portfolio occur with expected frequencies under the risk-neutral measure of 1.2, 41.5, and 763 years, respectively. On average, 65 percent of the CDX spread is due to firm-specific default risk, 27 percent to clustered industry or sector default risk, and 8 percent to catastrophic or systemic default risk. Recently, however, firm-specific default risk has begun to play a larger role.

Published in: Journal of Finance, Vol. 63, No. 2, (April 2008), pp. 529-563.

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