More than Two Bonds, Correlation, and Simulation
In this chapter we use the CDO (Collateralized Debt Obligation) idea described in Chapter 9 to build simulation sheets like those provided in Chapter 6. We can build some intuition about the way in which spreads over the actuarially fair rate can be distributed to the tranches, potentially to the benefit of all. We also develop some copula models which allow the effects of correlation to be simulated.
The work done above, with just two bonds in the CDO, is good for building intuition but is extremely unrealistic. In reality, a CDO will contain a very large number of bonds.
Let us do some work to see if we can relax the assumption of just ...