Pricing Collateralized Debt Obligations—The Basics

The CDS discussed above transfers the credit risk of a single entity from the protection buyer to the protection seller for a contracted period. Where protection buyers seek to securitize large portfolios of default risk prone loans, or even CDSs, the collateralized debt obligations (CDO) is used.

How is a loan portfolio different from a single loan? We have seen above that the individual firms (in a loan portfolio) could default, leading to losses in the portfolio value. This risk can be assessed by estimating the PD for each firm and the LGD (1 – RR). Additionally, the degree of dependence in the portfolio between firms’ default probability, known as ‘default correlation’, has an impact on ...

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