By Sivan Mahadevan, Peter Polanskyj, Vishwanath Tirupattur, Pinar Onur, Andrew Sheets
Read or Download Morgan Stanley Structured Credit Insights, 2nd Edition, 2006 PDF
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Extra info for Morgan Stanley Structured Credit Insights, 2nd Edition, 2006
Example text
Trading profits are used to supplement the excess spread. Trapping the excess spread until maturity or allow the leaking out of the excess spread only as long as the deal is performing satisfactorily are some other mechanisms used to address adverse selection issues. In many cases, trading ceases at some predefined point of the CDO life cycle or when trading losses reach a certain predefined level. Rating agencies review trading guidelines by focusing on isolating trading losses such that losses to investors in rated tranches come from credit events or risk management of credit risk in the underlying portfolio and not because of discretionary trading.
Using this approach, average factor loadings and average idiosyncratic risk exposures are computed for each industry-geographic region grouping and used to derive asset correlations. ANALYTICAL CHALLENGES IN MODELING SYNTHETIC CDOs While synthetic CDOs are significantly simpler than their cash counterparts in terms of valuation because of a significantly simpler waterfall, cash flow diversion rules and optional redemption potential, they still pose significant analytical challenges. While this is true both under a risk neutral valuation framework as well as objective or historical probabilities, the challenges are best understood juxtaposed against the former.
The 1/125th of the notional would be separated and the protection seller would pay par to the protection buyer in exchange of a deliverable obligation. After a default, the premium payments for the index would be (124/125)*Deal Spread, irrespective of which of the 125 names defaults (this methodology applies to CDX series 3, and may not hold for previous indices). This is due to the same deal spread for all underlying names in the index portfolio, as we mentioned earlier. It is important to note that an equal-weighted portfolio of underlying names could now have a different spread, given that the each of the underlying names has its own spread level and depending on which of the 125 names defaults, the average spread for the remaining 124 names could be different from 124/125 of the original spread.