An Empirical Analysis of the Pricing of Collateralized Debt Obligations
Francis A. Longstaff, Arvind Rajan
NBER Working Paper No. 12210
We study the pricing of collateralized debt obligations (CDOs) using an extensive new data set for the actively-traded CDX credit index and its tranches. We find that a three-factor portfolio credit model allowing for firm-specific, industry, and economywide default events explains virtually all of the time-series and crosssectional variation in CDX index tranche prices. These tranches are priced as if losses of 0.4, 6, and 35 percent of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65 percent of the CDX spread is due to firm-specific default risk, 27 percent to clustered industry or sector default risk, and 8 percent to catastrophic or systemic default risk. Recently, however, firm-specific default risk has begun to play a larger role.
Published: Longstaff, Francis A. and Arvind Rajan. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations." Journal of Finance 63, 2 (April 2008): 529-63.