CDO pricing with factor models: survey and comments

Leif Andersen and Jakob Sidenius

Journal of Credit Risk

Abstract: ABSTRACT Models with systematic factors are popular in the modeling of CDOs, mainly owing to their simplicity and tractability. In this small note we provide a general framework which we use to survey a number of CDO models that have appeared in the literature so far. We suggest extensions and also briefly discuss a select number of issues with factor models, ranging from calibration against CDO market data (ie, base correlation skews) to credit spread hedging and maturity extrapolation. We highlight a number of inherent limitations of factor models and also discuss certain idiosyncracies of popular model-independent approaches to computation of spread hedges.

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