Do Rare Events Explain CDX Tranche Spreads?

Sang Byung Seo and Jessica Wachter ()

No 22723, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We investigate whether a model with a time-varying probability of economic disaster can explain the pricing of collateralized debt obligations, both prior to and during the 2008-2009 financial crisis. Namely, we examine the pricing of tranches on the CDX, an index of credit default swaps on large investment-grade firms. CDX senior tranches are essentially deep out-of-the money put options because they do not incur losses until a large fraction of previously stable firms default. As such, these products clearly reflect the market’s assessment of rare-event risk. We find that the model can simultaneously explain prices on CDX senior tranches and on equity index options at parameter values that are consistent with the equity premium and with aggregate stock market volatility. Our results demonstrate the importance of beliefs about rare disasters for asset prices, even during periods of relative economic stability.

JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2016-10
Note: AP EFG
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Published as SANG BYUNG SEO & JESSICA A. WACHTER, 2018. "Do Rare Events Explain CDX Tranche Spreads?," The Journal of Finance, vol 73(5), pages 2343-2383.

Downloads: (external link)
http://www.nber.org/papers/w22723.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:22723

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w22723

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().