In recent years credit derivatives have become the main tool for transferring and hedging risk. The credit derivatives market has grown rapidly both in volume and in the type of the instruments it offers. Innovations in this market have been growing at an unprecedented pace, and will likely persist in the near future. Nowadays many newly financial securities are continuously developed. Amongst the most complicated of these instruments are the multiple underlying ones.
These are instruments with payoffs that are contingent on the default realization in a portfolio of obligors. Default risk at the level of an individual security has been extensively modeled using both structural and reduced form approach. However, default risk at the portfolio level is not so well understood. Default dependencies among many obligors in a large portfolio play a crucial role in the quantification of a portfolio’s credit risk exposure for the effects caused by simultaneous defaults and by the joint dependency between them. This dependency may be due to both macroeconomic (the overall economy) and microeconomic (sectorial and, even firm specific) aspects. These latter factors are referred in the literature as credit contagion.
In these latest years a relatively new financial instrument, that has payoffs depending on the joint default behavior of the underlying securities, is appeared: it is called Collateralized Debt Obligation (CDO).
A CDO comprises a pool of underlying instruments (called collateral) against which notes of debt are issued with varying cashflow priority. These notes vary in credit quality depending on the subordination level. At inception when each note is issued, it usually receives a rating from an independent agency. The collateral of a CDO is typically a portfolio of corporate bonds (or sovereign bonds, emerging markets bonds as well) or bank loans or other type of financial facilities (residential or commercial mortgages, leasing, lending, revolving facilities, even other credit derivatives, etc.).
CDOs create a customized asset class by allowing various investors to share the risk and return of an underlying pool of debt obligations. Hence, a CDO consists of a set of assets (its collateral portfolio) and a set of liabilities (the issued notes).
A CDO cash flow structure allocates interest income and principal repayment from a collateral pool of different debt instruments to a prioritized collection of securities notes, which are commonly called tranches. A standard prioritizing structure is a simple subordination, i.e. senior CDO notes are paid before mezzanine and lower subordinated notes are paid, with any residual cash flow to an equity piece. The tranches are ordered so that losses in interest or principal to the collateral are absorbed first by the lowest level tranche and then in order to the next tranche and so on.
The lowest tranche is the riskiest one, because has to respond immediately to the incurred losses, and it is called the equity tranche. The mechanism for distributing the losses to the various tranches is called the waterfall. Losses occur when there is a certain kind of credit event, explicitly defined in the offering circular. A credit event is usually either a default of the collateral, or a failure to pay of the collateral or other specified event according to the latest ISDA agreements. In either case, the market value of the collateral drops; and, consequently, the issued related notes are usually hit by a credit downgrade and by a market value slump.
