CDO Equity Returns and Return Correlation

There has been a good deal of research published on historic CDO equity returns, particularly with regard to the monthly volatility of equity returns, their Sharpe ratios,1 and the correlation of CDO equity returns to the returns of other assets. Unfortunately, the calculation of these variables is so fundamentally flawed that the results that have been reported to investors are useless. The reason is quite simple: The secondary market for CDO equity is undeveloped. As a result, there are no monthly prices for CDO equity. It follows that one cannot calculate monthly CDO equity returns, the monthly volatility of CDO equity returns, or a CDO equity Sharpe ratio. Nor can one correlate monthly CDO equity returns with those of other assets.

In this chapter, we investigate what part of the historic record has any bearing on future CDO equity returns. We conclude that the only historic data that provide insight into the future performance of CDO equity are the default and recovery of underlying CDO assets. Conse-quently, this limits the usefulness of the historic CDO equity return measures mentioned above, even if they could be calculated reliably.

We then make the most of available default and recovery data to examine the implication to CDO equity created in today's environment with either high-yield loan or structured finance underlying assets. Next, making some simplifying assumptions, we show that the correlation between CDO equity ...

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