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Credit Risk Models IV: Understanding and pricing CDOs

by Abel Elizalde of CEMFI & Universidad Pública de Navarra

April 2006

Abstract: Some investors in the Collateralized Debt Obligations (CDOs) market have been publicly accused of not fully understanding the risks and dynamics of these products. They won't have an excuse any more. This report explains the mechanics of CDOs: their implied cash flows, the variables affecting those cash flows, their pricing, the sensitivity of CDO price to those variables, the functioning of the markets where they are traded, their different types, the conventions used for trading CDOs, ... We built our description of CDOs pricing upon the Vasicek asymptotic single factor model because of its simplicity and the insights it provides regarding the pricing of CDOs. Additionally, we provide an extensive and updated review of the literature which extends the Vasicek model by relaxing its, somehow restrictive, assumptions in order to build more realistic and, as a consequence, more complicated CDO pricing models.

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