The Art of Credit Derivatives: Demystifying the Black Swan

17

One Credit Event Models for CDOs of ABS

The difference between genius and stupidity is that genius has its limits.

Albert Einstein

17.1 INTRODUCTION

In this chapter we compare algorithms to price CDOs of ABSs using MC simulation under the Gaussian copula. This is done using the 1-factor market approach under two different correlation assumptions and a multifactor model using an approach similar to the one developed by Fitch (Zelter et al., 2007) for Structured Finance CDOs. Additionally, we give the impact of four different assumptions for the amortization profiles.

The chapter is organized as follows. In Section 17.2 we show the approach used to price an ABS bond, and different assumptions for the amortization parameter and how to use it to imply default probabilities. In Section 17.3 we analyze the impact of the different model parameters for ABS pricing. In Section 17.4 we give a brief description of the multifactor Gaussian copula approach inspired by the Fitch model. In Section 17.5 we show how to get default times from simulated returns. In Section 17.6 we show the results of the simulations for the pricing of different tranches of the CDO of ABS. We conclude in Section 17.7.

17.2 ABS BOND AND ABCDS

In this section we give valuation formulas for an ABS bond and its CDS. Observe that the main difference between an ABS with respect to a simpler corporate bond is that due to amortization and the real possibility of prepayments the outstanding notional is time-dependent. ...