Modeling of CPDOs Identifying Optimal and Implied Leverage

by Jochen Dorn of the Université Paris1 Panthéon-Sorbonne

November 2007

Abstract: Considering the recent subprime crisis, the demand for collateralized products based on Credit Default Swap (CDS) exposures combined with security features is increasing. Constant Proportion Collateralized Debt Obligations (CPDOs) are a mixture of Collateralized Debt Obligations (CDOs) and CPPIs with inverse mechanism. This new asset targets to meet the upcoming investors' demand in the credit derivatives market, but quantitative approaches for pricing except for simulation algorithms do not exist yet up to he author's knowledge. This article aims to shed a light on CPDOs specific structural enhancements and mechanisms. The author quantifies inherent risks and provides a closed-form pricing formula.

JEL Classification: G12, G13, C02, C19.

EFM Classification: 310, 340, 410, 420.

Keywords: CPPI, Leverage, Shortfall, Barrier, Lévy Process.

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Related reading: Optimal Leverage Function for CPDOs