Professional Documents
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Duffie Garleanu 2001
Duffie Garleanu 2001
Debt Obligations
Darrell Duffie and Nicolae Gârleanu
In this discussion of risk analysis and market valuation of collateralized
debt obligations, we illustrate the effects of correlation and prioritization
on valuation and discuss the “diversity score” (a measure of the risk of the
CDO collateral pool that has been used for CDO risk analysis by rating
agencies) in a simple jump diffusion setting for correlated default
intensities.
collateralized debt obligation is an asset- main issue we address is the impact of the joint
January/February 2001 41
Financial Analysts Journal
Underlying CDO
Hedge Provider
Securities Special-Purpose
(if needed)
(collateral) Vehicle
Among the sources of illiquidity that promote, For a relatively small junk bond or a single
or limit, the use of CDOs are adverse selection, bank loan to a relatively obscure borrower, the
trading costs, and moral hazard. market of potential buyers and sellers may be
With regard to adverse selection, enough pri- small; thus, trading may be costly.2 Searching for
vate information may exist about the credit quality such buyers can be expensive, for example, and to
of a junk bond or a bank loan that an investor is sell such an illiquid asset quickly, one may be
concerned about being “picked off” when trading forced to sell to the highest bidder among the rela-
such an instrument. For instance, a better-informed tively few buyers with whom one can negotiate on
seller has an option to trade or not at the given short notice. One’s negotiating position may also
price. The value of this option is related to the be poorer than it would be in an active market. The
quality of the seller’s private information. Given value of the asset is correspondingly reduced.
the risk of being picked off, the buyer offers a price Potential buyers recognize that they are placing
themselves at the risk of facing the same situation
that, on average, is below the price at which the
when they try to resell in the future, which results
asset would be sold in a setting of symmetric infor-
in yet lower valuations. The net cost of bearing
mation. This reduction in price as a result of
these costs may be reduced through securitization
adverse selection is sometimes called a “lemon’s
into relatively large homogeneous senior CDO
premium” (Akerlof 1970).
tranches, perhaps with significant retention of
In general, adverse selection cannot be elimi- smaller and less easily traded junior tranches.
nated by securitization of assets in a CDO, but it can
Moral hazard, in the context of CDOs, bears on
be mitigated. The seller achieves a higher total the issuer’s or CDO manager’s incentives to select
valuation (for what is sold and what is retained) by high-quality assets for the CDO and to engage in
designing the CDO structure so as to concentrate costly enforcement of covenants and other restric-
into small subordinate tranches the majority of the tions on the behavior of obligors. Securitizing and
risk that may be cause for adverse selection. For selling a significant portion of the cash flows of the
example, a large senior tranche, relatively immune underlying assets dilute these incentives. Reduc-
to the effects of adverse selection, can be sold at a tions in value through lack of effort are borne to
small lemon’s premium. The issuer can retain, on some extent by investors. Also, the opportunity
average, significant fractions of the smaller subor- may arise for “cherry picking” (sorting assets into
dinate tranches, which are more subject to adverse the issuer’s own portfolio or into the SPV portfolio
selection. For models supporting this design and based on the issuer’s private information). In addi-
retention behavior, see DeMarzo (1999) and tion, opportunities may arise for front running, in
DeMarzo and Duffie (1999). which a CDO manager trades on its own account
in advance of trades on behalf of the CDO. These tranches, with their ratings. The bulk of the under-
moral hazards act against the creation of CDOs, lying assets are floating-rate NationsBank loans
because the incentives to select and monitor assets rated BBB or BB. Any fixed-rate loans were hedged
promote greater efficiency and higher valuation if in terms of interest rate risk by fixed-to-floating
the issuer retains a 100 percent interest in the asset interest rate swaps. As predicted by theory,
cash flows. NationsBank retained the majority of the (unrated)
The opportunity to reduce the other market lowest tranche.
imperfections through a CDO may be sufficiently Our valuation model does not deal directly
large—especially in light of the advantages in with the effects of market imperfections. It takes as
building and maintaining a reputation for not given the default risk of the underlying loans and
exploiting CDO investors—to offset the effects of assumes that investors are symmetrically
moral hazard. In this case, the issuer has an incen- informed. Although this approach is not perfectly
tive to design the CDO so that the issuer retains a realistic, it is not necessarily inconsistent with the
significant portion of one or more subordinate
roles of moral hazard or adverse selection in the
tranches that would be among the first to suffer
original security design. For example, DeMarzo
losses stemming from poor monitoring or poor
and Duffie demonstrated a “fully separating equi-
asset selection. Doing so demonstrates a degree of
librium,” in which the sale price of the security or
commitment to diligent efforts to manage the issue.
the amount retained by the seller signals to all
Similarly, for arbitrage CDOs, a significant portion
of the management fees may be subordinated to the investors any of the seller’s privately held value-
issued tranches (Schorin and Weinreich 1998). In relevant information. Moral hazard can be
light of this commitment, investors may be willing addressed by the model because the diligence of the
to pay more for tranches, and the total valuation to issuer or manager is, to a large extent, determined
the issuer will be higher than in an unprioritized by the security design and the fractions retained by
structure, such as a straight equity pass-through the issuer. Once these factors are known, the
security. Innes (1990) described a model that sup- default risk of the underlying debt is also known.
ports this motive for security design. Our simple model does not, however, account for
An example of a CLO structure consistent with the valuation effects of many other forms of market
this theory is shown in Figure 2. The figure illus- imperfections. Moreover, inferring separate risk
trates one of a pair of CLO cash flow structures premiums for default timing and default recovery
issued by NationsBank in 1997. A senior tranche of from the prices of the underlying debt and market
$2 billion in face value, whose credit rating is AAA, risk-free interest rates is generally difficult (see
is followed by successively lower subordination Duffie and Singleton 1999.) These risk premiums
Obligors
$2,164 million
A. $2,000 million
(AAA) B. $43 million
(A)
C. $54 million
(BBB)
D. $64 million
(not rated)
Source: Fitch.
January/February 2001 43
Financial Analysts Journal
play separate roles in the valuation of CDO We adopt a pre-intensity model that is a special
tranches. We simply take these risk premiums as case of the “affine” family of processes that have
given in the form of “risk-neutral” parametric mod- been used for this purpose and for modeling short-
els for default timing and recovery distributions term interest rates.5 Specifically, we suppose that
under an equivalent martingale measure. each obligor’s default time has some pre-intensity
process λ solving a stochastic differential equation
of the form
Default Risk Model
We lay out some of the basic default modeling for dλ ( t ) = κ [ θ – λ ( t ) ]dt + σ λ ( t ) dW( t ) + ∆J ( t ) , (3)
the underlying collateral. First, we propose a sim- where W is a standard Brownian motion and ∆J(t)
ple model for the default risk of one obligor. Then, denotes any jump that occurs at time t of a pure-
we turn to the multi-issuer setting. Throughout, we jump process J, independent of W, whose jump
work under risk-neutral probabilities, so value is sizes are independent and exponentially distrib-
given by expectations of discounted future cash uted with mean µ and whose jump times are those
flows. If objective likelihoods or variances are of of an independent Poisson process with mean jump
interest, however, the results should be interpreted arrival rate l . (Jump times and jump sizes are also
as if the probabilities were actual, not risk neutral. independent.6) We call a process λ of this form
(Equation 3) a basic affine process with parameters (κ,
Obligor Default Intensity. We suppose that θ, σ, µ, l ). These parameters can be adjusted in
each underlying obligor defaults at some expected several ways to control the manner in which default
arrival rate. The idea is that at each time t before the risk changes over time. For example, we can vary
default time τ of the given obligor, the default the mean-reversion rate κ, the long-run mean
arrives at some “intensity” λ(t), given all currently m = θ + ( l µ ) ⁄ κ , or the relative contributions to
available information. We thus have the approxi- the total variance of λt that are attributed to jump
mation risk and to diffusive volatility.
We can also vary the relative contributions to
P t ( τ < t + ∆t ) ≅ λ ( t )∆t (1)
jump risk of the mean jump size µ and the mean
for the conditional probability at the time t of jump arrival rate l . A special case is the no-jump
default within a “small” time interval ∆t > 0.3 For (l = 0) model of Feller (1951), which was used by
example, if time is measured in years (as we do Cox, Ingersoll, and Ross (1985) to model interest
here), a current default intensity of 0.04 implies that rates. From the results of Duffie and Kan (1996),
the conditional probability of default within the we can calculate that for any t and any s ≥ 0,
next three months is approximately 0.01. Immedi- α ( s ) + β ( s )λ ( t )
E t [ exp ( ∫t
t+s
– λ u du ) ] = e , (4)
ately after default, the intensity drops to zero. Sto-
chastic variation in the intensity over time, as new
where explicit solutions for the coefficients α(s) and
information becomes available, reflects any
β(s) are provided in Appendix A. Together, Equa-
changes in perceived credit quality. Correlation
tion 2 and Equation 4 give a simple, reasonably rich,
across obligors in the changes over time of their
and tractable model for the default time probability
credit qualities is reflected by correlation in the
distribution and how it varies at random over time
changes of those obligors’ default intensities.
as information arrives in the market.
Indeed, our model has the property that all correla-
tion in default timing arises in this manner.4 We call Multi-Issuer Default Model. To study the
a stochastic process λ a pre-intensity for a stopping implications of changing the correlation in the
time τ if whenever t < τ, first, the current intensity default times of the various participations (collat-
is λt and, second, eralizing bonds or loans) in a CDO while holding
constant the default risk model of each underlying
Pt ( τ > t + s ) = E t [ exp ( ∫t
t+s
– λ u du ) ] , s >0, (2) obligor, we will exploit the following result. We
state that a basic affine model can be written as the
where Et denotes conditional expectation given all sum of independent basic affine models as long as
information at time t and s is the length of the the parameters κ, σ, and µ governing, respectively,
period over which survival (no default) is consid- the mean reversion rate, diffusive volatility, and
ered. A pre-intensity need not fall to zero after mean jump size are common to the underlying pair
default. For example, default at a constant pre- of independent basic affine processes.
intensity of 0.04 means that the intensity itself is Proposition 1: Suppose X and Y are indepen-
0.04 until default and is zero thereafter. dent basic affine processes with respective
parameters (κ, θX, σ, µ, l X) and (κ, θY, σ, µ, l Y). easy. We can use the independence of the underly-
Then, X + Y is a basic affine process with ing state variables to see that
parameters (κ, θ, σ, µ, l ), where l = l X + l Y and
θ = θX + θY.7
E t exp [ ∫t – λ i ( u ) du ]
t+s
January/February 2001 45
Financial Analysts Journal
CDO structure consists of a special-purpose vehicle the 10-year par-coupon spread (in basis points) and
that acquires a collateral portfolio of participations the long-run variance of λi(t). To illustrate the qual-
(debt instruments of various obligors) and allocates itative differences between parameter sets, Figure
interest, principal, and default recovery cash flows 4 shows sample paths of new 10-year par spreads
from the collateral pool to the CDO tranches—and for two issuers, one with the base-case parameters
perhaps to a manager. (Set 1) and the other with pure-jump intensity (Set
2) calibrated to the same initial spread curve.
Collateral. The collateral pool has N participa-
tions. Each participation pays quarterly cash flows
to the SPV at its coupon rate until maturity or
default. At default, a participation is sold for its Table 2. Risk-Neutral Default Parameter Sets
recovery value and the proceeds from the sale are Spread
also made available to the SPV. Set κ θ σ l µ (bps) var∞
Let A(k) denote the subset of {1, . . ., N} contain- 1 0.6 0.0200 0.141 0.2000 0.1000 254 0.42
ing the surviving participations at the kth coupon 2 0.6 0.0156 0.000 0.2000 0.1132 254 0.43
period. The total interest income in coupon period 3 0.6 0.0373 0.141 0.0384 0.2500 253 0.49
k is then 4 0.6 0.0005 0.141 0.5280 0.0600 254 0.41
W(k) = ∑ Mi C
-----i , (13) With di denoting the event of default by the ith
i∈A ( k ) n participation, Table 3 shows for each parameter set
and each of three levels of the correlation parameter
where Mi is the face value of participation i and Ci
ρ, the unconditional probability of default and the
is the coupon rate on participation i.
conditional probability of default by one participa-
If B(k) denotes the set of participations default-
tion given default by another. Table 3 also shows
ing between coupon periods k – 1 and k,12 the total
the diversity score of the collateral pool that is
cash flow in period k is
implied by matching the (risk-neutral) variance of
the total loss of principal of the collateral portfolio
Z(k) = W(k) + ∑
i∈B ( k )
( Mi – Li ) , (14)
to that of a comparison portfolio of bonds of the
same individual default probabilities.14
where Li is the loss of face value at the default of For our basic examples, we suppose, first, that
participation i. any cash in the SPV reserve account is invested at
For our example, the initial pool of collateral the default-free short-term rate. We later consider
available to the CDO structure consists of N = 100 investment of SPV free cash flows in additional
participations that are straight quarterly coupon risky participations.
10-year par bonds of equal face value. Without loss
of generality, we take the face value of each bond Sinking-Fund Tranches. We consider a CDO
to be 1. structure that pays SPV cash flows to a prioritized
We initiate the common and the idiosyncratic sequence of sinking-fund bonds and a junior sub-
risk factors, Xc and Xi , at their long-run means, ordinated residual.
θc + l c µ/κ and θi + l i µ/κ, respectively. Thus, the
In general, a sinking-fund bond with n coupon
initial condition (and long-run mean) for each obli-
periods per year has some remaining principal,
gor’s (risk-neutral) default pre-intensity is 5.33 per-
F(k), at coupon period k, some annualized coupon
cent. Our base-case default-risk model is defined
rate c, and a scheduled interest payment at coupon
by Parameter Set Number 1 in Table 2 and by
letting ρ = 0.5 determine the degree of diversifica- period k of F(k)c/n. In the event that the actual
tion. The three other parameter sets shown in Table interest paid, Y(k), is less than the scheduled inter-
2 are designed to illustrate the effects of replacing est payment, any difference F(k)c/n – Y(k) is
some or all of the diffusive volatility with jump accrued at the bond’s own coupon rate, c, so as to
volatility or the effects of reducing the mean jump generate an accrued unpaid interest at period k of
size and increasing the mean jump arrival fre- U(k), where U(0) = 0 and
quency l .
All the parameter sets have the same long-run U ( k ) = 1 + --c- U ( k – 1 ) + --nc- F ( k ) – Y ( k ) . (15)
n
mean θ + µl /κ. The parameters θ, σ, l , and µ were
adjusted so as to maintain essentially the same term To prioritize payments in light of the default and
structure of zero-coupon yields, as illustrated in recovery history of the collateral pool, some pre-
Figure 3.13 Table 2 provides, for each parameter set, payment of principal, D(k), and some contractual
January/February 2001 47
Financial Analysts Journal
260
240
220
200
180
160
140
120
0 1 2 3 4 5 6 7 8 9 10
Maturity (years)
unpaid reduction in principal, J(k), may also occur rates of the tranches over the default-free par cou-
in period k. By contract, we have D(k) + J(k) ≤ F(k – pon rate.
1), so the remaining principal at quarter k is
Prioritization Schemes. We experiment with
F(k) = F(k – 1) – D(k) – J(k). (16)
the relative sizes and prioritization of two CDO
At maturity (coupon period number K), any bond tranches, one 10-year senior sinking-fund
unpaid accrued interest and unpaid principal, U(K) bond with some initial principal F1(0) = P1 and one
and F(K), respectively, are paid to the extent pro- 10-year mezzanine sinking-fund bond with initial
vided in the CDO contract. (A shortfall does not principal F2(0) = P2. The residual junior tranche
constitute default so long as the contractual priori- receives any cash flow remaining at the end of the
tization scheme is maintained.15) The total actual 10-year structure. Because the base-case coupon
payment in any coupon period k is Y(k) + D(k). rates on the senior and mezzanine CDO tranches
The par coupon rate on a given sinking-fund are, by design, par rates, the base-case initial mar-
bond is the scheduled coupon rate c with the prop- ket value of the residual tranche is P3 = 100 – P1 – P2.
erty that the initial market value of the bond is At the kth coupon period, tranche j has a face
equal to its initial face value, F(0). If the default-free value of Fj(k) and accrued unpaid interest Uj(k)
short rate r(k) is constant, as in our results, any calculated at its own coupon rate, cj. Any excess
sinking-fund bond that pays all remaining princi- cash flows from the collateral pool (interest income
pal and all accrued unpaid interest by or at its and default recoveries) are deposited in a reserve
maturity date has a par coupon rate equal to the account. To begin, we suppose that the reserve
default-free coupon rate, no matter the timing of account earns interest at the default-free one-
the interest and principal payments. period interest rate, denoted r(k) at the kth coupon
We illustrate our initial valuation results in date. At maturity, coupon period K, any remaining
terms of the par coupon spreads of the respective funds in the reserve account after payments at
tranches, which are the excess of the par coupon quarter K to the two tranches are paid to the
Figure 4. New 10-Year Par-Coupon Spreads for The reserve available before payments at
the Base-Case Parameters and for period k, R(k), is thus defined by [recall that Z(k) is
the Pure-Jump Intensity Parameters the total cash flow from the participations in
Coupon Spread period k]
(basis points)
r(k)
600 R ( k ) = 1 + ----------
4
(17)
a × [ R ( k – 1 ) – Y1 ( k – 1 ) – Y2 ( k – 1 ) ]
550
z + Z(k) .
500 Unpaid reductions in principal from default
losses occur in reverse priority order, so the junior
450 residual tranche suffers the reduction
J3(k) = min[F3(k – 1), H(k)], (18)
400
where
350
H ( k ) = max ∑ L i – [ W ( k ) – Y 1 ( k ) – Y 2 ( k ) ] , 0 , (19)
300 i ∈B ( k )
January/February 2001 49
Financial Analysts Journal
payments as quickly as possible until maturity or ability that more than one default will occur during
until its principal remaining is reduced to zero, one time step is very small; hence, we ignore it.
whichever is first. Until the senior tranche is paid Based on experimentation, we chose to simu-
in full, the mezzanine tranche accrues unpaid inter- late 10,000 pseudo-independent scenarios.16
est at its coupon rate. Then, the mezzanine tranche
is paid interest and principal as quickly as possible Results for Par CDO Spreads. The esti-
until maturity or until the mezzanine tranche is mated par spreads of the senior (s1) and mezzanine
retired. Finally, any remaining cash flows are allo- (s2) CDO tranches for the four-parameter sets are
cated to the residual tranche. Specifically, in cou- shown in Table 4 for various levels of overcollater-
pon period k, the senior tranche is allocated the alization and for the two prioritization schemes. To
interest payment, illustrate the accuracy of the simulation methodol-
ogy, we show in parentheses estimates of the stan-
Y1(k) = min[U1(k), Z(k)] (22a)
dard deviation of these estimated spreads resulting
and the principal payment from “Monte Carlo noise.” Table 5 and Table 6
D1(k) = min[F1(k – 1), Z(k) – Y1(k)], (22b) show estimated par spreads for the case of, respec-
tively, “low” (ρ = 0.1) and “high” (ρ = 0.9) default
where the total cash generated by the collateral correlations. In all these examples, the risk-free rate
pool, Z(k), is again defined by Equation 14. The is 0.06 and no management fees are considered.
mezzanine receives the interest payments,
Y2(k) = min[U2(k), Z(k) – Y1(k) – D1(k) – Y2(k)] (23a)
and principal payments Table 4. Par Spreads (ρ = 0.5)
D2(k) = min[F2(k – 1), Z(k) – Y1(k) – D1(k) – Y2(k)]. (23b) (estimated standard deviation in
parentheses)
Finally, any residual cash flows are paid to the
junior subordinated tranche. For this scheme, no Uniform Scheme Fast Scheme
contractual reductions in principal occur [that is, Set s1 s2 s1 s2
Ji (k) = 0]. Principal: P1 = 92.5; P2 = 5
In practice, many other types of prioritization 1 18.7 bps 636 bps 13.5 bps 292 bps
schemes are possible. For example, during the life (1) (16) (0.4) (1.6)
of a CDO, failure to meet certain contractual over- 2 17.9 589 13.5 270
collateralization ratios in many cases triggers a shift (1) (15) (0.5) (1.6)
to some version of fast prioritization. For our exam- 3 15.3 574 11.2 220
ples, the CDO yield spreads for uniform and fast (1) (14) (0.5) (1.5)
prioritization would provide upper and lower 4 19.1 681 12.7 329
bounds, respectively, on the senior spreads that (1) (17) (0.4) (1.6)
would apply if one were to add such a feature to the
uniform prioritization scheme that we illustrated. Principal: P1 = 80; P2 = 10
1 1.64 bps 67.4 bps 0.92 bps 38.9 bps
Simulation Methodology. Our computa- (0.1) (2.2) (0.1) (0.6)
tional approach consists of simulating piecewise lin- 2 1.69 66.3 0.94 39.5
ear approximations of the paths of Xc and X1, . . ., XN (0.1) (2.2) (0.01) (0.6)
for time intervals of some relatively small fixed- 3 2.08 51.6 1.70 32.4
length ∆t. (We use a ∆t interval of one week.) (0.2) (2.0) (0.2) (0.6)
Defaults during one of these intervals are simulated 4 1.15 68.1 0.37 34.6
at the corresponding discretization of the total (0.1) (2.0) (0.2) (0.6)
arrival intensity,
Figure 5 and Figure 6 illustrate the impacts on
Λ(t) = ∑ i λi ( t )1A ( i, t ) , (24)
the market values of the three tranches of a given
CDO structure of changing the correlation param-
where the variable 1A(i,t) equals 1 if issuer i has not eter ρ (with uniform prioritization). The base-case
defaulted by t and equals 0 otherwise. (That is, only CDO structures used for this illustration were
the intensities of the participations still alive are determined by uniform prioritization of senior and
summed.) When a default arrives, the identity of the mezzanine tranches whose coupon rates are at par
defaulter is drawn at random, with the probability for the base-case Parameter Set 1 and with the
that i is selected as the defaulter given by the discret- correlation parameter ρ = 0.5. For example, suppose
ization approximation of λi(t)1A(i,t)/Λ(t). The prob- this correlation parameter is moved from the base
Principal: P1 = 80; P2 = 10
1 0.27 bps 17.6 bps 0.13 bps 7.28 bps 0
2 0.31 17.5 0.15 7.92
3 0.45 14.9 0.40 6.89
4 0.16 19.0 0.05 6.69
–0.5
Table 6. Par Spreads (ρ = 0.9) ρ = 0.1 ρ = 0.5 ρ = 0.9
Uniform Scheme Fast Scheme
Initial Correlation
Set s1 s2 s1 s2
Senior Mezzanine Junior
Principal: P1 = 92.5; P2 = 5
1 30.7 bps 778 bps 23.9 bps 420.bps Note: Uniform prioritization. The premium is the market value
2 29.5 687 23.7 397 net of par.
3 25.3 684 20.6 325
4 32.1 896 23.1 479 Figure 6. Impact on Tranche Value of Correla-
tion: Low Overcollateralization
Principal: P1 = 80; P2 = 10 (P1 = 92.5)
1 3.17 bps 113.bps 1.87 bps 68.8 bps
Premium
2 3.28 112 1.95 70.0
(percentage of face value)
3 4.03 90 3.27 60.4
0.8
4 2.52 117 1.06 65.4
0.6
case of 0.5 to 0.9. Figure 6, which treats the case of 0.4
relatively little subordination available to the
senior tranche (P1 = 92.5), shows that the loss in 0.2
diversification reduces the market value of the 0
senior tranche from 92.5 to about 91.9. The market
value of the residual tranche, which benefits from –0.2
volatility in the manner of a call option, increases –0.4
from 2.5 to approximately 3.2, a dramatic relative
–0.6
change. Although a precise statement of convexity
is complicated by the timing of the prioritization –0.8
effects, the effect illustrated by Figures 5 and 6 is ρ = 0.1 ρ = 0.5 ρ = 0.9
along the lines of Jensen’s inequality; an increase in Initial Correlation
correlation also increases the (risk-neutral) vari-
ance of the total loss of principal. These opposing Senior Mezzanine Junior
reactions to diversification of the senior and junior Note: Uniform prioritization. The premium is the market value
tranches also show that the residual tranche may net of par.
offer some benefits to certain investors as a volatil-
ity hedge against default risk for the senior tranche.
The mezzanine tranche absorbs the net effect
of the impacts of correlation changes on the market the collateral portfolio is not affected by the corre-
values of the senior and junior residual tranches (in lation of default risk. These effects can be compared
this example, the result is a decline in market value with the impact of correlation on the par spreads of
of the mezzanine from 5.0 to approximately 4.9), the senior and mezzanine tranches that are shown
which it must do because the total market value of in Tables 4, 5, and 6. Clearly, given the relatively
January/February 2001 51
Financial Analysts Journal
small size of the mezzanine principal, the mezza- Figure 7. Risky Reinvestment: Senior Tranche
nine par spreads can be dramatically influenced by Spreads
correlation. Moreover, experimenting with various
Spread (bps)
mezzanine overcollateralization values shows that
30
the effect is ambiguous: Increasing default correla-
tion may raise or lower mezzanine spreads.
25
Prioritization Scheme. For our example,
ensuring faster payments to the senior and then to 20
the mezzanine tranches makes these tranches safer;
that is, their par coupon spreads are smaller when 15
the fast prioritization scheme is adopted. For the
senior tranche, this statement holds for two rea-
10
sons: This tranche risks no contractual loss of prin-
cipal (and hence no contractual loss of future
interest) and it loses no interest payments to the 5
mezzanine tranche. For the mezzanine tranche, the
statement holds in our example because the effect 0
of experiencing no contractual principal losses is 1 2 3 4
stronger than that of postponing the interest pay- Parameter Set
ments, which carries the risk of not receiving them
in full. Tables 4–6 provide the computed spreads. Safe Reinvestment Risky Reinvestment
Analytical Results 0
In this section, exploiting the symmetry assump- 1 2 3 4
tions of our special example, we provide analytical
Parameter Set
results for the probability distribution for the num-
ber of defaulting participations and the total of Safe Reinvestment Risky Reinvestment
default losses of principal, including the effects of
random recovery.
ance under permutation) in the unconditional joint
The key to calculating these probability distri-
distribution of default times,
butions exactly is the ability to explicitly compute
the probability of survival of all participations in any P(M = k) =
chosen subgroup of obligors. These explicit proba- N P(d ∩ … ∩ d ∩ d c c (25)
bilities must be evaluated with extremely high k 1 k k + 1 ∩ … ∩ d N ),
of the first j names will default by T is computed Equations A2 and A3 for the case in which n = –κ,
later; for now, we take this calculation as given. p = σ2, q = –j, l = l c, and m = κθc; αi(T) and βi(T) are
Proposition 2: We have17 the explicitly given solutions of Equations A2 and
A3 for the case in which n = –κ, p = σ2, q = –1, l = l i,
N
(j + k + N + 1) k and m = κθi.
q ( k, N ) = ∑ ( –1 ) p .
N – j j
(27)
It is not hard to see how to generalize Proposi-
j=1
tion 2 so as to accommodate more than one type of
A proof, found in the Duffie and Gârleanu 1999 intensity—that is, how to treat a case with several
working paper, is based on a careful counting of the internally symmetric pools. Introducing each such
number of scenarios in which k participations group increases by one the dimensions of the array
default. Using the fact that the pre-intensity of the p, however, and the summation. Thus, given the
first-to-arrive τ(j) = min(τ1, . . ., τj) of the stopping relatively lengthy computation required to obtain
times τ1, . . ., τj is λ1 + . . . + λj and using the adequate accuracy for even two subgroups of issu-
independence of X1, . . ., XN and Xc, we have ers, one might prefer simulation to this analytical
approach for multiple types of issuers.
( j) Based on this analytical method, Figure 9
pj = 1 – P [ τ > T]
shows the probability q(k, 100) of k defaults within
j
10 years out of the original group of 100 issuers for
= 1 – E exp – ∫0 ∑ λ i ( t ) dt
T
(28)
i=1 Parameter Set 1 for a correlation-determining
parameter ρ that is high (0.9) or low (0.1). Figure 10
α c ( T ) + β c ( T )X c ( 0 ) + jα i ( T ) + jβ i ( T )X i ( 0 )
= 1–e , shows the associated cumulative probability func-
tions, including the base case of ρ = 0.5. For exam-
where αc(T) and βc(T) are given explicitly in Appen- ple, from Figure 9, the likelihood of at least 60
dix A as the solutions of the ordinary differential defaults out of the original 100 participations in 10
0.07
0.06
ρ = 0.1
0.05
0.04
0.03
0.02
ρ = 0.9
0.01
0
0 10 20 30 40 50 60 70 80 90 100
Number of Defaults, k
January/February 2001 53
Financial Analysts Journal
Figure 10. Cumulative Probability of Number of Defaults: High, Low, and Base-Case Correlation
Probability of k or Fewer Defaults
1.0
0.8
0.6
0.4
0.2
0
0 10 20 30 40 50 60 70 80 90 100
Number of Defaults, k
years is on the order of 1 percent for the low- bution rather than through a much more arduous
correlation case, whereas it is roughly 12 percent simulation of the pre-intensity processes. The algo-
for the high-correlation case. One can use this rithm is roughly as follows:
method to compare the probability q(k, 100) of k • Simulate n draws from the explicit distribution
defaults across all four parameter sets.18 of the default time of a participation in the
One can also compute analytically the likeli- comparison portfolio. Record those default
hood of a total loss of principal of a given amount times that are before T—say, M in number—
x.19 The approach is to add up, over k, the proba- and ignore the others.
bilities q(k, 100) of k defaults multiplied by the prob- • Simulate M fractional losses of principal.
abilities that the total loss of principal from k • Allocate cash flows to the CDO tranches,
defaults is at least x.20 A sample of the resulting loss period by period, according to the desired pri-
distributions is illustrated in Figure 11. oritization scheme.
One can also analytically compute the variance • Discount the cash flows of each CDO tranche
to a present value at risk-free rates.
of total loss of principal, from which come diversity
• For each tranche, average the discounted cash
scores, as tabulated for our example in Table 3. A
flows over independently generated scenarios.
description of the computation of diversity scores
A comparison of the resulting approximation
for a general pool of collateral, not necessarily with
of CDO spreads with those computed earlier is
symmetric default risk, is in Appendix B. Given a
provided for certain cases in Figures 12–14. For
(risk-neutral) diversity score of n, one can estimate well-collateralized tranches, the diversity-based
CDO yield spreads by a much simpler algorithm, estimates of spreads are reasonably accurate (as
which approximates by substituting the compari- shown in Figures 12 and 14), at least relative to the
son portfolio of n independently defaulting partic- uncertainty that one would in any case have
ipations for the actual collateral portfolio. regarding the actual degree of diversification in the
The default times can be independently simu- collateral pool. For highly subordinated tranches
lated directly from an explicit unconditional distri- and with moderate or large default correlations, the
Figure 11. Probability Density of Total Losses of Principal through Default: High Correlation
Probability Density
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0 10 20 30 40 50 60
Set 1 Set 3
Set 2 Set 4
Figure 12. Spread Comparisons for Senior Figure 13. Spread Comparisons for Mezzanine
Tranches: High Correlation (ρ = 0.9), Tranches: Moderate Correlation
Low Subordination (P1 = 92.5) (ρ = 0.5), Low Subordination
(P1 = 92.5, P2 = 5)
Spread (bps)
40 Spread (bps)
1,200
30 1,000
800
20
600
400
10
200
0 0
1 2 3 4 1 2 3 4
January/February 2001 55
Financial Analysts Journal
diversity-based spreads can be rather inaccurate, as Figure 14. Spread Comparisons for Mezzanine
can be seen in Figure 13. Tranches: Moderate Correlation
Another source of approximation error from (ρ = 0.5), High Subordination
diversity-score-based calculations is concentration (P1 = 80, P2 = 10)
risk in the original portfolio. Suppose, for example,
Spread (bps)
that the notional amount of one obligor is a large
80
fraction of the total notional amount of the collat-
eral pool. The hypothetical comparison portfolio,
with equal notional amounts to each obligor, may
60
have tail risk of default losses that is markedly
smaller than the tail risk of the actual portfolio,
despite having the same mean and variance of
40
default losses. One might allow for concentration
risk by construction of a comparison portfolio with
similar concentration but still assuming no correla-
20
tion of default losses.
Figure 15 shows the likelihood of a total loss of
principal of at least 24.3 percent of the original face
0
value as the correlation-determining parameter ρ is 1 2 3 4
varied. The figure also illustrates the calculation of
the probability of failing to meet an overcollateral- Parameter Set
ization target.
Full-Simulation Spread Diversity-Score Spread
January/February 2001 57
Financial Analysts Journal
N
∫
t(j)
var ∑ L i d i = Np ( 1 ) E ( L i )
2 – λ j ( u ) du
i=1 –E e
0 (B5)
2 (B2)
+ N ( N – 1 )p ( 2 ) [ E ( L i ) ]
∫
t(j)
– b ( t )X ( t ) du
0
2 2 2 +E e ,
–N p( 1 ) [ E ( Li ) ] .
Notes
1. A synthetic CLO differs from a conventional CLO in that Unfortunately, regulations do not always provide the same
for a synthetic CLO, the bank originating the loans does not capital relief for a synthetic CLO as for a standard balance
actually transfer ownership of the loans to the SPV but, sheet CLO (see Punjabi and Tierney 1999).
instead, uses credit derivatives to transfer the default risk 2. This issue is related to the effects of adverse selection, but
to the SPV. A synthetic CLO may be preferred when the it also depends on the total size of the issue.
direct sale of loans to SPVs might compromise client rela- 3. Supporting technical details are provided in the Duffie and
tionships or secrecy or would be costly because of contrac- Gârleanu 1999 working paper.
tual restrictions on transferring the underlying loans.
4. An alternative would be a model in which simultaneous 13. Because all parameter sets have the same κ parameter,
defaults could be caused by certain common credit events. maintaining the same term structure of zero-coupon yields
An example is a multivariate exponential model (see Duffie was a rather straightforward numerical exercise, with
and Singleton 1998). Another alternative is a contagion Equation 4 used for risk-neutral default probabilities.
model, such as the static “infectious default” model of 14. This calculation is based on the analytical methods
Davis and Lo (1999). described in the next section, “Analytical Results.”
5. An affine interest-rate process is one in which zero-coupon 15. As a practical matter, if the investors’ losses from default in
yields are linear with respect to underlying state variables. the underlying collateral pool are sufficiently severe,
For a more precise definition, see Duffie and Kan (1996). Moody’s may assign a “default” to a CDO tranche even if
6. A technical condition that is sufficient for the existence of a it meets its contractual payments.
strictly positive solution to Equation 3 is that κθ ≥ σ2/2. We 16. The basis for this approach and other multi-obligor default-
do not require it because none of our results depends on time simulation approaches is discussed in Duffie and Sin-
gleton (1998).
strict positivity. m
17. We use the convention that = 0 if l < 0 or m < l .
7. A proof can be found in the Duffie and Gârleanu 1999 l
working paper. The method of the proof is to verify that the 18. We have not included the graphs in this article, but we note
Laplace transform of Xt + Yt is that of an affine process with that low-correlation distributions are rather more similar
initial condition X0 + Y0 and parameters (κ, θ, σ, µ, l ). across the various parameter sets than are high-correlation
8. Our model is “doubly stochastic,” in the sense that, condi- distributions. The full set of graphs is in the Duffie and
tional on the processes λ1, . . ., λN, the default times τ1, . . ., Gârleanu 1999 working paper.
τn are independent and are the first jump times of counting 19. We are referring to the risk-neutral likelihood, unless the
processes with these respective intensities. Thus, the only model under the objective probability is used.
source of default time correlation in our model is through 20. For computation, we did not use the actual distribution of
correlation in the intensity processes. the total fractional loss of principal of a given number k of
9. A modeling alternative allowing for the treatment of corre- defaulting participations. For ease of computation, we sub-
lated interest rate risk, and technical details, is in the 1999 stituted with a central limit (normal) approximation for the
Duffie and Gârleanu working paper. distribution of the sum of k identically and independently
distributed uniform (0, 1) random variables, which is
10. This pricing approach was developed by Lando (1998) for
merely the distribution of a normally distributed variable
slightly different default intensity models. Lando also
with the same mean and variance. We were interested in
allowed for correlation between interest rates and default this calculation for moderate to large levels of x, corre-
intensity. sponding to, for example, estimating the probability of
11. Moody’s would not rely exclusively on the diversity score failure to meet an overcollateralization target. We have
in rating CDO tranches. verified that, even for relatively few defaults, the central
12. That is, B(k) is the subset of A(k – 1) that is not in A(k). limit approximation is adequate for our purposes.
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