Structuring and Rating Cash-flow CDOs with Rating Transition Matrices
by Domenico Picone of the Cass Business School - London
May 5, 2005
Abstract: The objective of this article is to prepare a time-inhomogeneous intensity model for valuing cash-flow CDOs, which explicitly incorporates the credit rating of the firms in the collateral portfolio as the indicator of the likelihood of default. Our model can prove very useful for the pricing, structuring, rating and risk management of CDO notes, whenever the legal structure of the transaction, includes waterfall triggers linked to the credit ratings of the firms in the collateral portfolio. If the waterfall triggers are breached, they divert cash due to pay the interests of the junior notes to accelerate the amortisation of the more senior notes. For this reason, we believe that in order to measure the risk and value of the CDO notes, it is necessary to combine a credit risk model with the exact cash-flow waterfall model of the given structure.