Abstract
The aim of the paper is to contribute to the understanding of CDOs and shed light on CDO valuation based on data before and during the current financial upheaval. We present the One Factor Gaussian Copula Model and examine five hypotheses regarding CDO sensitivity to entry parameters.
For our modeling we used data of the CDX NA IG 5Y V3 index from 20 September 2007 until 27 February 2009 and we appropriately transform its quotes into CDO quotes. Based on the results we discovered four main deficiencies of the CDO market: i) an insufficient analysis of underlying assets by both investors and rating agencies; ii) investment decisions arise from the valuation model based on expected cash-flows, they neglected other factors such mark-to-market losses; iii) mispriced correlation; and finally iv) obligation of the mark-to-market valuation.
Based on the mentioned recommendations we conclude that the CDO market has a chance to be regenerated. However, it would then be more conscious, driven by smarter motives rather than by pure arbitrage and profit incentives.