Risk transfer with CDOs

Modern bank management comprises both classical lending business and transfer of asset risk to capital markets through securitization. Sound knowledge of the risks involved in securitization transactions is a prerequisit
Modern bank management comprises both classical lending business and transfer of asset risk to capital markets through securitization. Sound knowledge of the risks involved in securitization transactions is a prerequisite for solid risk management. This paper aims to resolve a part of the opaqueness surrounding credit-risk allocation to tranches that represent claims of different seniority on a reference portfolio. In particular, this paper analyzes the allocation of credit risk to different tranches of a CDO transaction when the underlying asset returns are driven by a common macro factor and an idiosyncratic component. Junior and senior tranches are found to be nearly orthogonal, motivating a search for the where about of systematic risk in CDO transactions. We propose a metric for capturing the allocation of systematic risk to tranches. First, in contrast to a widely-held claim, we show that (extreme) tail risk in standard CDO transactions is held by all tranches. While junior tranches take on all types of systematic risk, senior tranches take on almost no non-tail risk. This is in stark contrast to an untranched bond portfolio of the same rating quality, which on average suffers substantial losses for all realizations of the macro factor. Second, given tranching, a shock to the risk of the underlying asset portfolio (e.g. a rise in asset correlation or in mean portfolio loss) has the strongest impact, in relative terms, on the exposure of senior tranche CDO-investors. Our findings can be used to explain major stylized facts observed in credit markets.
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Metadaten
Author:Jan Pieter Krahnen, Christian Wilde
URN:urn:nbn:de:hebis:30-56426
Parent Title (English):Universität Frankfurt am Main. Fachbereich Wirtschaftswissenschaften: [Working paper series / Finance and accounting] Working paper series, Finance & Accounting ; No. 187
Series (Serial Number):Working paper series / Johann-Wolfgang-Goethe-Universität Frankfurt am Main, Fachbereich Wirtschaftswissenschaften : Finance & Accounting (187)
Publisher:Univ., Fachbereich Wirtschaftswiss.
Place of publication:Frankfurt am Main
Document Type:Working Paper
Language:English
Year of Completion:2008
Year of first Publication:2008
Publishing Institution:Univ.-Bibliothek Frankfurt am Main
Release Date:2008/07/28
Tag:credit risk; risk transfer; systematic risk
SWD-Keyword:Bank; Risikoverteilung; Schuldverschreibung
Issue:April 2008
Pagenumber:26
HeBIS PPN:202489795
Institutes:Wirtschaftswissenschaften
Dewey Decimal Classification:330 Wirtschaft
JEL-Classification:G21 Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G28 Government Policy and Regulation
Sammlungen:Universitätspublikationen
Licence (German):License Logo Veröffentlichungsvertrag für Publikationen

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