CDO Valuation and Cash Flow Waterfall Models
To complete our discussion of synthetic collateralised debt obligations (CDOs), this chapter presents an overview of the main principles in CDO valuation. To assist understanding we will consider cash as well as synthetic CDOs. We do not discuss one common approach, Moody’s Binomial Expansion technique, which is covered in existing literature that is readily accessible, and made available by Moody’s. However, we present some key concepts that will set the scene satisfactorily for practitioners.
The valuation of note tranches in a CDO structure is a function of a number of factors, an important one of which is the credit quality of the underlying portfolio. This is measured by aggregating individual securities’ default probabilities, and by also considering their default correlation and diversity. If the portfolio experiences a deterioration in credit quality, this has the biggest impact on the equity tranche, because this has a leveraged exposure to the portfolio and is the first-loss piece. Other factors that impact the valuation of the tranches include:
- if there are changes in the level of portfolio diversification, which increase concentration risk and may have a negative impact;
- if the underlying assets are viewed as being risky relative to a more recent CDO issue;
- if any of the rating agency guidelines are ignored or compliance tests are breached;
- if the cost of funding on the liabilities side is variable but ...