Dynamic Pricing of Synthetic Collateralized Debt Obligations

by Robert Lamb of Imperial College,
William Perraudin of Imperial College, and
Astrid van Landschoot of Standard & Poor's

March 2008

Abstract: This paper applies a new class of dynamic credit loss rate models to the pricing of benchmark synthetic Collateralized Debt Obligations (CDOs). Our approach builds directly on the static, industry-standard, pricing approach to credit structured products based on Vasicek (1991). We generalize the Vasicek model by allowing risk factors to be driven by arbitrarily complex autoregressive processes. We show how to benchmark our model using CDX prices, and demonstrate that it can consistently and accurately fit the prices of multiple tranches with different subordination levels and tenors. Among other interesting results, we find that changes in tranche spreads are driven less by alterations in the market's estimate of default correlation (which is stable over time) and more by fluctuations in market perceptions of the persistence of credit shocks, i.e., the persistence of the credit cycle.

JEL Classification: G12, G13.

Keywords: Synthetic CDO, Dynamic loss distributions, Vasicek model, Default rates, Loss model.

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