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Quantitative Finance by Matt Davison

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Chapter 9

Tranching and Collateralized Debt Obligations

9.1 CHAPTER SUMMARY

This chapter presents a brief description of the first “engineered” financial product we shall meet: the so-called “Collateralized Debt Obligation,” or CDO. These products present a way for converting debt with one risk profile into other debt products with other, different, risk profiles. The resulting idea can be used to make money from inconsistencies in the risk-reward profile observed in the corporate debt market.

After introducing CDOs in Section 9.2, we perform a quantitative analysis of the structure in Section 9.3, using some results about bonds which can default in two distinct ways with two distinct recovery rates in Section 9.4. In particular, we use this ...

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