Nber Working Paper Series an Empirical Analysis of the Pricing of Collateralized Debt Obligations

We study the pricing of collateralized debt obligations (CDOs) using an extensive new data set for the actively-traded CDX credit index and its tranches. We find that a three-factor portfolio credit model allowing for rm-speci c, industry, and economywide default events explains virtually all of the time-series and crosssectional variation in CDX index tranche prices. These tranches are priced as if losses of 0.4, 6, and 35 percent of the portfolio occur with expected frequencies of 1.2, 41.5, and 763 years, respectively. On average, 65 percent of the CDX spread is due to firm-specific default risk, 27 percent to clustered industry or sector default risk, and 8 percent to catastrophic or systemic default risk. Recently, however, firm-specific default risk has begun to play a larger role. Francis A. Longstaff UCLA Anderson Graduate School of Management 110 Westwood Plaza, Box 951481 Los Angeles, CA 90095-1481 and NBER [email protected]