Credit risk management

1. Managing Credit Risk Under The Basel III Framework 193
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Collateralized Debt Obligations
14
KEY CONCEPTS
• Cash flow CDO
• Synthetic CDO
• Market value CDO
• CDO rating
14 Collateralized debt obligations
14.1 Credit securitization
In general, credit risky debts have an illiquid secondary market primarily due to the
following two reasons:
• There is a persistent mis-match between demand and supply of debts in terms of risk-
return characteristics. In general, there is a strong demand on high quality debts but
only a very limited supply on high quality debts; and
• The information asymmetry on a debt creates a large spread between the bid and ask
prices. An owner who has invested in a debt for some time has more understanding
on the specific risk of a debt and demands a higher ask price. An investor who
intends to acquire a debt from the secondary market has limited understanding on the
specific risk of a debt and offers a lower bid price.
Through the process of credit securitization over a debt portfolio, structured credit
instruments in the form of collateralized debt obligations (“CDOs”) are created and
tailored to match the demand from investors. The specific risks of individual debts are
diversified away, leaving only the systematic risk on which most investors have a
common understanding.
14.2 Structuring
14.2.1 Cash flow CDO ★★★★★★★★★★★★
At its origination, a CDO family, supported by a debt portfolio well approximated by an
infinite homogeneous portfolio,36
comprises several CDO tranches, each with its own
tranche principal, tranche interest rate and seniority. The sum of all tranche principals,
referred to as the total tranche principal, is equal to the portfolio principal and the total
interest amount to be distributed to the CDO tranches is equal to the sum of interests
generated by the portfolio principal.
36
The theories for modelling CDOs created by a heterogeneous portfolio are not well developed. The high
model error makes such kind of CDOs less welcome to the CDO market, in particular after the financial
tsunami 2008.

2. 194 Managing Credit Risk Under The Basel III Framework
Copyright 2018 CapitaLogic Limited
A CDO tranche is specified by a portfolio attachment point (“PAP”) and a portfolio
detachment point (“PDP”) of the portfolio principal. A PAP is the percentage of
portfolio principal from which the CDO tranche starts to suffer from default loss in the
tranche principal. A PDP is the percentage of portfolio principal up to which the CDO
tranche will suffer from total default loss. The most junior tranche has a PAP 0 percent
while the most senior tranche has a PAP 100 percent but no detachment point.
Alternatively, a CDO tranche can be specified by a tranche attachment point (“TAP”) and
a tranche detachment point (“TDP”) of the portfolio principal. A TAP is the percentage
of total tranche principal from which the CDO tranche starts to suffer from default loss in
the tranche principal. A TDP is the percentage of total tranche principal up to which the
CDO tranche will suffer from total default loss. The most junior tranche has a TAP 0
percent while the most senior tranche has a TDP 100 percent.
Obviously, the TAP and PAP are connected with the relationship:
TAP = PAP × LGD
and, except for the ultra senior tranche, the TDP and PDP are connected with the
relationship:
TDP = PDP × LGD
Figure 14.1 Cash flow re-distribution through credit securitization
On an interest payment day, the most senior tranche has the priority to collect the
interests generated from the debt portfolio until either the entitled tranche interest amount
is collected in full or the interests from the debt portfolio are exhausted, i.e.:
Tranch interest rate
Tranche principal ,
Interest frequency
Min
Portfolio interest rate
Portfolio principal
Interest frequency
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× 
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