Measuring the Credit Risk of Synthetic CDOs with CDS-Implied Ratings

Abstract

Market price-based measures of credit risk have become commonplace in single-name risk management, but they are lacking for structured credit instruments such as CDOs. In this article, the authors demonstrate how CDS-implied ratings for corporate reference entities, together with an analytic portfolio risk model, can be used to derive CDS-implied tranche ratings for corporate synthetic CDOs (CSOs). It is an experiment in which one key variable is changed—the ratings of the portfolio of reference entities—while holding other data and model assumptions constant. The authors create two parallel rating histories for the CDO tranches, one using Moody’s corporate ratings for the reference entities and one using CDS-implied ratings for the same entities, and measure and compare how the derived tranche ratings perform. They find that CDS-implied tranche ratings lead changes in Moody’s ratings, are no more volatile than Moody’s-based ratings, more accurately rank order default losses by rating, and exhibit higher loss prediction accuracy ratios for the riskiest tranches.

TOPICS: CLOs, CDOs, and other structured credit, credit default swaps, information providers/credit ratings