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Stressing rating criteria allowing for default clustering: the CPDO case

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  • Torresetti, Roberto
  • Pallavicini, Andrea

Abstract

After a brief review of the literature on rating arbitrage for corporate and structured nance, we introduce the standard criteria adopted by rating agencies to assess riskiness of Constant Proportion Debt Obligations (CPDO). Then, we propose a new rating model in order to incorporate a more realistic loss distribution showing a multi-modal shape, which, in turn, is linked to default possibilities for clusters (possibly sectors) of names of the economy. In this framework, we show that the riskiness of CPDOs is substantially increased leading to a decrease of their rating, and in particular, we found that the expected payout of the gap-risk option, embedded in CPDOs, is greatly enhanced.

Suggested Citation

  • Torresetti, Roberto & Pallavicini, Andrea, 2007. "Stressing rating criteria allowing for default clustering: the CPDO case," MPRA Paper 17104, University Library of Munich, Germany, revised 04 Sep 2009.
    • Handle: RePEc:pra:mprapa:17104
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    File URL: https://mpra.ub.uni-muenchen.de/17104/1/MPRA_paper_17104.pdf
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    References listed on IDEAS

    as
    1. Bangia, Anil & Diebold, Francis X. & Kronimus, Andre & Schagen, Christian & Schuermann, Til, 2002. "Ratings migration and the business cycle, with application to credit portfolio stress testing," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 445-474, March.
    2. Lando, David & Skodeberg, Torben M., 2002. "Analyzing rating transitions and rating drift with continuous observations," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 423-444, March.
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    Cited by:

    1. Damiano Brigo & Andrea Pallavicini & Roberto Torresetti, 2009. "Credit models and the crisis, or: how I learned to stop worrying and love the CDOs," Papers 0912.5427, arXiv.org, revised Feb 2010.

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    More about this item

    Keywords

    CPDO Rating; Rating Arbitrage; Structured Finance; Loss Distribution; Loss Dynamics; Cluster Default Dynamics; Gap Risk;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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