CDO², Correlation, Overlap, and Subordination

Abstract

In this article, the author prices and assesses the risk of CDO² and, more precisely, he highlights the complex relationships among the dependence structure of the underlying assets packaged in the inner CDOs, the level of subordination of the single-tranche CDOs, and the performance of the single-tranche CDO² (ST CDO²) itself. The article also investigates the crucial role of the correlation parameter and provides several numerical examples to point out the complex impact of this parameter on the risk profile and the valuation of ST CDO². Investors looking for trade ideas involving long or short positions in correlation should be interested in the results.