Valuation of collateralized debt obligations: An equilibrium model

Abstract

In this paper, we present a new equilibrium model for pricing collateralized debt obligations (CDOs). The model is grounded on option pricing theory and features a random jump size to account for default correlation across reference entities. This feature is important for pricing CDOs during times of market turmoil. Simulation results show that jump size volatility, capturing uncertainty about the size of simultaneous corporate defaults, is a key parameter in pricing CDOs. The effect of jump size volatility on CDO spreads is substantial and depends on the relative position of the mean jump size to loss-coverage limits.