The Definitive Guide to CDOsMarket, Application, Valuation and Hedging

Edited by Gunter Meissner

Risk&oo&s

Contents

List of Figures ix

List of Tables xvii

About the Editor xxi

About the Authors xxiii

Introduction xxxiiiGunter Meissner

SECTION 1: THE CDO MARKET AND APPLICATION

Introduction 3

1 The Evolution of CDOs - From the Bistro to CDO2 5Brenda Boultwood; Gunter MeissnerJP Morgan; University of Hawaii, NYU and Derivatives Software

2 The Application of CDOs 21Gunter MeissnerUniversity of Hawaii, NYU and Derivatives Software

SECTION 2: BASIC PROPERTIES OF CDO VALUATION

Introduction 35

3 An Overview on Copula Function Methods in CreditPortfolio Modelling 39David Xianglin LiChina International Capital Corporation Limited

4 The Underlying Dynamics of Credit Correlations 73Arthur Berd; Robert Engle; Artem VoronovCapital Fund Management; Stern School of Business,New York University; Millgate Capital

5 Dynamic Conditioning and Credit Correlation Baskets 117Claudio Albanese; Alicia VidlerLevel 3 Finance; Merrill Lynch

6 Approaches to Generate the Loss Distribution 161Peter Grundke; Thomas MoosbruckerUniversity of Osnabriick; Deloitte & Touche GmbH

7 Modelling Non-Normal CDO Returns with the OmegaFunction 187Ranjan Bhaduri; Gunter MeissnerAlphaMetrix, World Trade University; University of Hawaii,NYU and Derivatives Software

CONTENTS

SECTION 3: CDO VALUATION APPROACHES

Introduction 201

8 The Market Standard Model for Valuing CDOs, the One-FactorGaussian Copula Model - Benefits and Limitations 207Gunter MeissnerUniversity of Hawaii, NYU and Derivatives Software

9 Practical Pricing of Synthetic CDOs 223Jon Gregory; Jean-Paul LaurentSS Consulting; Universite de Lyon, Universite Lyon 1,ISFA Actuarial School, and BNP Paribas

10 Factor Models for CDO Pricing 259Leif Andersen, Victor L. PiterbargBane of America Securities

11 Levy Processes for the Valuation of CDO Tranches 293Thomas MoosbruckerDeloitte & Touche GmbH

12 Markov Models for CDOs 319Erik SchloglUniversity of Technology, Sydney »

13 CDOs2: Time for an Autopsy? 341Michiko WhettenUBS Securities Japan

14 Constant Proportion Debt Obligations: An Introduction 363Martin Hellmich; Stefan KassbergerDekaBank; Ulm University

15 A Comparative Analysis of CDO Pricing Models 389Xavier Bitrtschell; Jon Gregory; Jean-Paul LaurentBNP Paribas; SS Consulting; Universite de Lyon, UniversiteLyon 1, ISFA Actuarial School and BNP Paribas

16 CDO Valuation: Fact and Fiction 429Robert A. Jarrow; Li Li, Mark Mesler, Donald R. van DeventerJohnson Graduate School of Management, Cornell Universityand Kamakura Corporation; Kamakura Corporation

SECTION 4: HEDGING OF CDOs

Introduction 459

17 Hedging Issues for CDOs 461Areski Cousin; Jean-Paul LaurentUniversite de Lyon, University Lyon 1, ISFA Actuarial School;University de Lyon, University Lyon 1, ISFA Actuarial Schooland BNP Paribas

CONTENTS

18 Hedging CDOs in the One-Factor Gaussian Copula Framework 481Gunter Meissner; Richard Hector, Thomas RasmussenUniversity of Hawaii, NYU and Derivatives Software; HawaiiPacific University

SECTION 5: RATING APPROACHES, REGULATORY ISSUES ANDMODEL VALIDATION

Introduction 503

19 A Comparative Analysis of Fitch's, Moody's andStandard & Poor's CDO Rating Approaches 507Gunter Meissner; Tim Gamier, Tobias LauteUniversity of Hawaii, NYU and Derivatives Software; HawaiiPacific University

20 The Treatment of CDOs in Basel II 529Martin Brodka, Linda UrbanLehman Brothers

21 Counterparty Credit Risk of CDO Tranches under Basel II 553Mall WhelanScotiabank

22 Model Validation and CDOs - An Overview of Requirementsand Methods 577George Neal

American Savings Bank

SECTION 6: CDOS - RISKS, CHALLENGES AND MARKET OUTLOOK

Introduction 593

23 CDOs - Risks, Challenges and Market Outlook 595David M. Rowe, Cyril DeretzSunGard

Index 631