Friday, February 13, 2009

Dresdner Kleinwort CDO and Longevity Swap Models

by Domenico Picone and colleagues posted on DefaultRisk.com:

Infinitely large homogeneous portfolio CDO model:

  • In the first part of our series we release the Large Homogenous Pool Model in the standard version as well as a version using the Gauss-Hermite Integration technique.
  • This publication has been structured as a user guide to be used in conjunction with the excel-based model. Whilst we do briefly touch upon the main theoretical concepts, we do not go into detailed explanations and proofs, as this information has been widely discussed and is readily available. Instead, we focus on how to implement the theory and apply the models.
  • Given the simplified assumptions behind this model, it is not a pricing tool for CDO tranches but instead is the first step to allow the user to appreciate the impact of key parameters such as correlation, recovery and spread on the value of a specific tranche.
  • Additionally, as the pool is considered to have an infinite and identical number of obligors, aspects such as idiosyncratic risk are not specifically treated. We will relax and analyse these points in the upcoming models.

Download spreadsheet : here. Download manual (700K PDF) 19 pages

With Gauss-Hermite integration : here. Download manual (631K PDF) 13 pages

Finite, homogeneous pool model:

  • After having released the Large Homogenous Pool Model in the first part of our series, we now move towards the Finite Homogenous Pool model.
  • Given the simplified assumptions behind this model, it is not a pricing tool for CDO tranches but instead is the first step to allow the user to appreciate the impact of key parameters such as correlation, recovery and spread on the value of a specific tranche.
  • Additionally, as the pool is considered to have a finite and identical number of obligors, aspects such as idiosyncratic risk are not specifically treated. We will relax and analyse these points in the upcoming models.

Download spreadsheet : here.

Analysing default risk of credit portfolios and CDOs:

  • In our CDO model series we have so far released various models with increasing flexibility and sophistication.
  • While they all have the advantage of being analytical / closed form solution models, they require simplifying assumptions with respect to the way credits may default together.
  • Most importantly, they all use a factor model to generate joint default events.
  • If the way credits default together is introduced without a factor model:
    • We can't apply the recursive algorithm anymore (as it depends on conditioning on a common factor).
    • However, Monte Carlo (MC) techniques can be used to simulate joint default events.
  • Within a MC approach, copulas allow for a very general and flexible way to directly model the dependency within the portfolio.
  • The current credit crisis has highlighted the importance of tail events in risk management. This model gives credit investors the tool to analyse the behaviour of their credit portfolio under stressed market conditions.

Download spreadsheet : here. Download manual (631K PDF) 13 pages

European RMBS: Cashflow dynamics and key assumptions:
  • Forced sales, lack of liquidity and of investor demand have pushed European Prime RMBS spreads to unprecedented levels. Currently AAA European RMBS are offering secondary spreads between 450-600bp. Launch spreads (pre-crisis) were in the range of 10-25bp.
  • Several distressed funds, and some real money investors, are increasingly looking at this sector with the aim of identifying good quality paper trading below fundamental value with the aim of monetising on the current dislocation and thereby capturing the large liquidity premium that markets are presently pricing in. We expect this theme to emerge strongly in the first half of 2009.
  • However, unlike standard corporate bonds, the increased cashflow complexity of RMBS means that it is important to understand the underlying model framework and the impact of key assumptions on future returns. In our view, ratings are just a starting point.
  • With this in mind, we have build an excel-based European RMBS model, incorporating all the key features of a typical cashflow model used to structure deals. In addition to showing how S&P and Fitch model the key assumptions, we have also provided the flexibility for user specific assumptions to understand sensitivities of different tranches.
  • With this model, after having recently published a series of CDO models, we continue our effort to increase transparency in the market. Going forward we also plan to release CLO, CMBS and Longevity Risk models.
  • In this presentation we initially look at some specific building blocks for a cashflow model before turning to our spreadsheet.

Download spreadsheet : here. Download manual (556K PDF) 16 pages

A Model for longevity swaps: Pricing life expectancy

  • In addition to the obvious exposure each and everyone of us has to mortality, economic agents such as pension funds, insurers and governments are exposed to mortality and to its flip-side longevity risk.
  • OECD pension funds had about USD 18tr of assets under management in 2007, and through their defined benefit pension schemes are massively exposed to longevity risk, as increases in life expectancy create additional costs. They are "short longevity".
  • In Europe, the UK and the Netherlands, because of the size of their pension fund markets, would be the greatest beneficiaries of a liquid longevity market.
  • Life settlements and mortality cat bonds have been used in the past to transfer very specific forms of longevity risk. Annuity buyouts have also been offered some form of risk relief for UK DB pension funds.
  • With regulators also forcing pension funds and life insurers to take a more active stance in managing longevity risk, longevity derivatives are likely to become the instrument of choice to manage this risk.
  • The longevity swap offers the simplest and easiest way to standardise the transfer of longevity risk between pension funds, insurers and new longevity investors looking at this market for diversification benefits.
  • With the attached spreadsheet to price the longevity swap, we distribute our implementation of the Lee Carter ‘92 model, which we used to forecast future German mortality rates, the main input for pricing.

Download spreadsheet : here. Download manual (589K PDF) 12 pages

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