Four Synthetic CDO Trading Strategies
ANDREA PETRELLI, JUN ZHANG, SANTA FEDERICO, AND VIVEK KAPOOR
A common market standard has evolved for the pricing of synthetic CDOs, as described in Chapter 10. This has been the subject of much research and discussion. Less understood are the risk-reward profiles of popular CDO trading strategies and the associated capitalization requirements. Indeed, there is no commonly agreed risk and capital model for even the index product tranches. There are two main reasons for this state of affairs:
1. The popular techniques for pricing CDO tranches have not directly addressed replication and hedging errors (accounting for spread diffusion, spread jumps, and jumps to default with uncertain recovery) ...