Abstract
This paper aims to reveal the mechanism of Collateralized Debt Obligations (CDOs) and how CDOs extend the current global financial crisis. We first introduce the concept of CDOs and give a brief account of the de-velopment of CDOs. We then explicate the mechanism of CDOs within a concrete example with mortgage deals and we outline the evolution of the current financial crisis. Based on our overview of pricing CDOs in various existing random models, we propose an idea of modeling the random phenomenon with the feature of heavy tail dependence for possible implements towards a new random modeling for CDOs.
Highlights
Introduction to Collateralized Debt Obligations (CDOs)Collateralized Obligations (COs) are promissory notes backed by collaterals or securities
This paper aims to reveal the mechanism of Collateralized Debt Obligations (CDOs) and how CDOs extend the current global financial crisis
Thereafter more and more extensions have been proposed to pricing CDOs: homogeneous infinite portfolio is extended to homogeneous finite portfolio, and to heterogeneous finite portfolio which represents the most real case; multifactor models are considered other than one factor model; Gaussian copula is replaced by alternative probability distribution functions; the assumptions of constant default probability, constant default correlation and deterministic loss given default are relaxed and stochastic ones are proposed which incorporate dynamics into pricing models
Summary
Collateralized Obligations (COs) are promissory notes backed by collaterals or securities. In the market for COs, the securities can be taken from a very wide spectrum of alternative financial instruments, such as bonds (Collateralized Bond Obligations, or CBO), loans (Collateralized Loan Obligations, or CLO), funds (Collateralized Fund Obligations, or CFO), mortgages (Collateralized Mortgage Obligations, or CMO) and others Frequently, they source their collaterals from a combination of two or more of these asset classes. Securitization may improve liquidity, and thereby raise the total valuation to the issuer of the CDO structure In light of these market imperfections, at least two classes of CDOs are popular: the balance-sheet CDO and the arbitrage CDO. An arbitrage CDO, often underwritten by an investment bank, is designed to capture some fraction of the likely difference between the total cost of acquiring collateral assets in the secondary market and the value received from management fees and the sale of the associated CDOs structure
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