CDOs in Chains

by Johan de Kock of Fraunhofer ITWM,
Holger Kraft of the University of Kaiserslautern, and
Mogens Steffensen of the University of Copenhagen

January 24, 2007

Abstract: This paper discusses the pricing of CDOs in a Markov chains framework. We show that in general the values of the legs satisfy systems of partial differential equations. In the special case of constant default intensities, one only needs to solve a system of ordinary differential equations, the so-called Kolmogorov differential equations.

JEL Classification: G13, G33.

Keywords: Markov chains, credit risk, credit derivatives, contagion.

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