Model specification and collateralized debt obligation (mis)pricing

Abstract

Complex structured products, especially collateralized debt obligations (CDOs), were at the center of the 2008 credit crisis. This paper explores the impact of modeling difficulties on CDO mispricing. Comparing pricing outputs among models with different specifications, we show that the use of a model with advanced default correlation assumptions could have reduced the amount of model-implied AAA-rated CDO securities. This pricing difference also has predictive power for the subsequent downgrading of AAA-rated CDO tranches. However, the model specification is only qualitatively important for CDO mispricing, as it has a modest quantitative effect in explaining the overall pricing errors.