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The Impossible Trio in CDO Modeling

Author

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  • Emmanuel Schertzer
  • Yadong Li
  • Umer Khan

Abstract

We show that stochastic recovery always leads to counter-intuitive behaviors in the risk measures of a CDO tranche - namely, continuity on default and positive credit spread risk cannot be ensured simultaneously. We then propose a simple recovery variance regularization method to control the magnitude of negative credit spread risk while preserving the continuity on default.

Suggested Citation

  • Emmanuel Schertzer & Yadong Li & Umer Khan, 2010. "The Impossible Trio in CDO Modeling," Papers 1012.0475, arXiv.org.
    • Handle: RePEc:arx:papers:1012.0475
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    File URL: http://arxiv.org/pdf/1012.0475
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