The Art of Credit Derivatives: Demystifying the Black Swan

14

Cash Flow CDOs

Ignorance is not knowing something, stupidity is not admitting your ignorance.

Daniel Turov

14.1 INTRODUCTION

This chapter starts with a short explanation of what collateralized debt instruments are and how investors might use them, mainly focusing on the rating of simple cash flow CDO using the binomial expansion technique (BET), originally developed by Moody’s. We give detailed descriptions of the waterfall and the BET. We then test how the model parameters affect the rating of the different tranches of a real cash flow CDO contract.

We cover the historical purpose of describing in detail the use of the BET approach to rate a cash flow CDO. Although the technique is quite old and usually deemed outdated, anecdotal evidence shows that many companies still use it, and that it may have been one of the causes behind the fall of a very large American insurance company dealing with a portfolio of CDOs. Moreover, the diversity score (DS), a key concept underlying the model, is still very much at the forefront of many portfolio managers’ minds, making it useful to describe the underpinning of the BET framework. The model is shown in an algorithmic way, making it easy to be reproduced in academia. Additionally, the chapter provides data and a structure in which the parameters of the model are changed, showing how they impact the rating of the different tranches. By describing the algorithm in a detailed fashion it becomes very clear that there is no way one can have ...