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CDOs and the financial crisis: Credit ratings and fair premia

Marcin Wojtowicz

Journal of Banking & Finance, 2014, vol. 39, issue C, 1-13

Abstract: We study risk and return characteristics of CDOs using the market standard models. We find that fair spreads on CDO tranches are much higher than fair spreads on similarly-rated corporate bonds. Our results imply that credit ratings are not sufficient for pricing, which is surprising given their central role in structured finance markets. This illustrates limitations of the rating methodologies that are solely based on real-world default probabilities or expected losses and do not capture risk premia. We also demonstrate that CDO tranches have large exposure to systematic risk and thus their ratings and prices are likely to decline substantially when credit conditions deteriorate.

Keywords: Collateralized debt obligations; Credit ratings; Fair premia; Structured finance; Rating agencies; Financial crisis (search for similar items in EconPapers)
JEL-codes: C52 G01 G11 (search for similar items in EconPapers)
Date: 2014
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Handle: RePEc:eee:jbfina:v:39:y:2014:i:c:p:1-13