Collateralized Debt Obligations: Structure and Valuation

Abstract

Derivatives are financial instruments that transfer risk from one party to another. They can be classified according to the kind of risk transmitted. For instance, we distinguish between interest rate derivatives, foreign exchange derivatives, commodity derivatives, equity derivatives, and credit derivatives. In the following, we focus on credit derivatives which transfer the credit risk exposure between two parties. By means of credit derivatives it is possible to acquire or reduce credit risk exposure. Credit risk includes default risk, downgrade risk, and credit spread risk (see Lucas et al. (2006)). In this study we concentrate on default risk, which is the risk that the issuer of a bond or the debtor of a loan will not repay the outstanding debt in full. The default can be either complete, when no amount of the bond or the loan is repaid, or partial, when only a part of the original debt is recovered.