The Impossible Trio in CDO Modeling

Details The Impossible Trio in CDO Modeling The Impossible Trio in CDO Modeling

2010-12-02

arxiv.org/abs/1012.0475v1

Economy

Quantitative Finance

Pricing of Securities

12 pages, 4 figures

Scientific paper

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.

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