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Model specification and collateralized debt obligation (mis)pricing
Author(s) -
Luo Dan,
Tang Dragon Yongjun,
Wang Sarah Qian
Publication year - 2018
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.21932
Subject(s) - collateralized debt obligation , debt , credit derivative , business , obligation , actuarial science , econometrics , economics , credit risk , collateral , finance , political science , law
Complex structured products, especially collateralized debt obligations (CDOs), were at the center of the 2008 credit crisis. This paper explores the impact of modeling difficulties on CDO mispricing. Comparing pricing outputs among models with different specifications, we show that the use of a model with advanced default correlation assumptions could have reduced the amount of model‐implied AAA‐rated CDO securities. This pricing difference also has predictive power for the subsequent downgrading of AAA‐rated CDO tranches. However, the model specification is only qualitatively important for CDO mispricing, as it has a modest quantitative effect in explaining the overall pricing errors.