Comparing BET and Copulas for Cash Flows CDO's

by João Garcia of Dexia Group,
Tom Dewyspelaere of Dexia Group,
Luc Leonard of Dexia Group,
Thomas Alderweireld of Dexia Group, and
Tony Van Gestel of Dexia Group

January 31, 2005

Abstract: This paper begins with a short explanation of collateralised debt obligations (CDO's) and how investors are using them. We describe the copula approach and the Binomial Expansion Technique (BET) developed by Moody's. The models are then tested on a real contract cash flow CDO showing the different aspects of the methodologies and how their assumptions influence the expected and unexpected losses of the deals. We show the sensitivities of the notes (for the BET and the copulas) to changes on interest rates, recovery rates, correlation, overcollateralization and average rating of the portfolio. Special attention is given to check those sensitivities on copula approach using S&P and Moody's corrleation assumptions. We finish by showing the care that should be exercised by investors when analysing CDO's using the two methodologies.

JEL Classification: G19, C19.

Keywords: Collateralised Debt Obligations, Copulas, BET, Cash Flow CDO's.

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