The Impossible Trio in CDO Modeling

by Emmanuel Schertzer of the Barclays Capital,
Yadong Li of the Barclays Capital, and
Umer Khan of the Barclays Capital

November 30, 2010

Abstract: We show that stochastic recovery always leads to counter-intuitive behaviors in the risk measures of a CDO tranche - namely, continuity on default and positive credit spread risk cannot be ensured simultaneously. We then propose a simple recovery variance regularization method to control the magnitude of negative credit spread risk while preserving the continuity on default.

JEL Classification: G13.

Keywords: CDO, stochastic recovery, continuity on default

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