R² publishes innovative CLO valuation paper in the Journal of Credit Risk
Toronto, October 1st 2010.
In a new paper published in the fall 2010 issues of the Journal of Credit Risk, Jovan Nedeljkovic and Dan Rosen, of R2Financial Technologies, together with David Saundersm, of the University of Waterloo, propose an innovative and parsimonious framework for pricing collateralized loan obligation (CLO) tranches under consistent dynamics across the capital structure, which provides an alternative to the current industry standard base correlation approach. Unlike the base correlation and related copula approaches, the methodology requires a single correlation parameter across the entire capital structure of a CLO. The dynamics of the model includes stochastic loan prepayments and recovery values in default, both of which are dependent on the same systematic factors. Furthermore, the model incorporates the empirically observed negative correlation between default rate and recovery value in default, as well as between prepayments and defaults. Prepayment speed and recovery value are both critical considerations underlying reliable CLO prices. The performance of the model is analyzed across a three-month period in 2008, during the credit crisis. The model calibrates very well to observed prices for the CDX.HY and LCDX indices, and provides stable implied distributions for the systematic factor. Furthermore, it gives robust, consistent prices and sensitivities for CLOs and CLO-squared transactions, even during this very volatile period.
The Weighted Monte Carlo methodology with implied market factors is implemented is in production in the latest version of the NxR2 platform for valuing and measuring the risk of Bespokes CDOs, CLOs and RMBS structures. The application of the methodology for Bespoke CDOs was discussed in a previous 2009 Journal of Credit Risk paper by the authors, and a third paper with the application of the methodology to RMBS structures will be published in a forthcoming volume by Wiley this year. For more information, please contact marketing@R2-financial.com.