An Empirical Analysis of the Pricing of Collateralized Debt Obligations




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      Francis Longstaff, Allstate Professor of Insurance and Finance, UCLA Anderson School and the NBER. Arvind Rajan, Managing Director, Relative Value Trading, Citigroup. We are grateful for the valuable comments and suggestions received from Vineer Bhansali, Pierre Collin-Dufresne, Keith Crider, Sanjiv Das, Darrell Duffie, Youseff Elouerkhaoui, Bjorn Flesaker, Kay Giesecke, Ben Golub, Mitch Janowski, Holger Kraft, David Lando, L. Sankarasubrahmanian, Alan Shaffran, David Shelton, Ken Singleton, Jure Skarabot, Ryoichi Yamabe, Jing Zhang, and seminar participants at Columbia University, the Federal Reserve Bank of New York, Harvard Business School/Harvard Department of Economics, IXIS Capital Markets, the Journal of Investment Management Conference, the NBER Summer Institute, New York University, Pimco, Stanford, the University of British Columbia, the University of California at Berkeley, the University of California at Los Angeles, the University of Michigan, and Yale University. We are particularly grateful for the comments and suggestions of the editor Campbell Harvey and an anonymous referee and associate editor. We also thank Guarav Bansal, Yuzhao Zhang, and Xiaolong Cheng for capable research assistance. All errors are our responsibility.


We use the information in collateralized debt obligations (CDO) prices to study market expectations about how corporate defaults cluster. A three-factor portfolio credit model explains virtually all of the time-series and cross-sectional variation in an extensive data set of CDX index tranche prices. Tranches are priced as if losses of 0.4%, 6%, and 35% of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65% of the CDX spread is due to firm-specific default risk, 27% to clustered industry or sector default risk, and 8% to catastrophic or systemic default risk.