New Model Attempts to Price CDO Options

In the aftermath of the CDO (collateralized debt obligation) crisis, for firms that are ready to dive into securitized credit products again, a new pricing model came out today for valuing exotic credit products such as options on tranches and forward starting CDOs (a forward starting CDO is a single tranche CDO with a specified premium starting at a specified future time).The new offering is a two-dimensional, intensity-based Markovian model of stochastic loss. Basically, it provides a new way (but based on work done around the turn of the century by mathematician Andrey Markov) of trying to determine the "default intensity," in other words, the probability that certain loans in a CDO will default.

Where in the past, models such as the Gaussian Copula have been used to arrive at CDO prices, "the time is right for the next generation of models," says Meng Lu, senior vice president of financial engineering at Numerix, provider of the new model. "This two-dimensional Markov model can be considered one of the next-generation dynamic credit basket models. One of the most significant benefits of using this new model is you have one unified model that is able to capture tranches with different maturities and different attachment and detachment points."

The model can be calibrated to CDO indices, such as the iTraxx credit default swap indices and the CDX, that provide the market view of what similar, liquid, traded products are selling for. "Much like the price of oil is an indicator of inflation, the value of these indices and the tranches on these indices will tell you what's happening in the credit markets," says Kevin Samborn, senior vice president of integration and services at Numerix. "Often when the market overcorrects -- which it clearly has done on some of the big banks, because they're really not any more likely to default than they were before the subprime crisis -- people look at these prices and think that now credit protection is cheap. If you have Countrywide in your CDO basket, that becomes important as well as the correlation between whether Countrywide will default and whether Citibank will default." But Samborn also acknowledges that this model and others can't take into account credit derivatives that have been improperly constructed. "The basic premise of what was going on in the subprime crisis -- of taking risky consumer debt and repackaging it as high-grade institutional products -- is just plain questionable," he says. And unmodelable.

Samborn claims that during the CDO/subprime mortgage mess, this software "would have been able to help you get a better view on the value of your instruments that previously wouldn't have been possible. If you have the option to buy a CDO, our software will give you an accurate price for it," he says. And the fact that the model evaluates options on CDOs, which can be used as hedging instruments, might have helped mitigate risk. "Previously you may not have been able to use options as a strategy because you couldn't get a price on them at all, it was all or nothing," he says. "Now you have a theoretical value for them, you can price them and use them."

The new model is available through the standard Numerix framework of Microsoft Excel, Numerix Portfolio, Numerix toolkits and certain software partners. Samborn says it is critical that firms use the same pricing model software in the front office where traders tend to use Excel, the middle office where trades are booked and the back office and risk systems. "That's the only way you can get a full, firm-wide view of your risks," he says. "If the trader books it using one model and has one view of the market, and the risk manager is using something that's two years old, they're not going to have the same view on what the instrument is worth."