Valuation of Complex Financial Instruments for Credit Risk Transfer

The fair valuation of complex financial products for credit risk transfer (CRT) can provide a good basis for sustained growth of these markets and their recovery after the current financial crisis. Therefore, the risks of these structured credit securities (such as Collateralized Debt Obligations (CDO) and Credit Default Swap-Index tranches) have to be known as well as the investor’s current risk aversion. Many (even sophisticated) investors rely solely on agencies’ ratings for the risk assessment and the valuation of CRT-products due to an information asymmetry between the originators and them. The use of an identical rating scale both for structured products like tranches and corporate securities like bonds tempted many investors to apply identical risk profiles to all products with identical ratings. However, the risk characteristics of CDO tranches differ significantly from comparably rated corporate bonds in relation to systematic risk. Additionally, investors assign different prices to equal cash-flows depending on their risk aversions. Due to the high marginal utility of cash-flows in bad economic times these should have higher weights in a risk valuation approach than income in a benign market environment. In this article we focus our study on the quite liquid and transparent market of the CDS-Index “iTraxx Europe” and related tranches. We compare market spreads of the tranches with spreads obtained from (I) a simple valuation model integrating the systematic risk sensitivity of tranches and (II) an extended valuation model additionally integrating the investor’s risk aversion. Based on our economical reasoning valuation models we obtain significantly differing prices for the investigated complex financial instruments for CRT compared to the market quotations.