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Credit Risk Frontiers: Subprime Crisis, Pricing and Hedging, CVA, MBS, Ratings, and Liquidity by Frédéric Patras, Damiano Brigo, Tomasz R. Bielecki

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Chapter 20

Stressing Rating Criteria Allowing for Default Clustering: The CPDO Case

Roberto Torresetti

Quaestio Capital Management, Milano

Andrea Pallavicini

Banca Leonardo, Financial Engineering

After a brief review of the literature on rating arbitrage for corporate and structured finance, we introduce the standard criteria adopted by rating agencies to assess the riskiness of constant proportion debt obligations (CPDOs). Then, we propose a new rating model in order to incorporate a more realistic loss distribution showing a multimodal shape, which, in turn, is linked to default possibilities for clusters (possibly sectors) of names in the economy. In this framework, we show that the riskiness of CPDOs is substantially increased, leading to ...

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