Volume 13, Numbers 1 & 2 / March/June , Pages 1-154
The Risks in CDO-Squared Structures
Multinational Finance Journal, 2009, vol. 13, no. 1/2, pp. 55-74
Andrew Adams , University of Edinburgh Business School, U.K.    Corresponding Author
Rajiv Bhatt , Deloitte Touche Tohmatsu India Pvt. Ltd., India
James Clunie , Scottish Widows Investment Partnership, U.K.

Abstract:
The recent sub-prime debacle has brought ‘innovative’ structured credit products such as collateralized debt obligations under severe criticism. The complexity of some structured finance securities and difficulties in understanding their risks has been a common theme. This paper argues that CDO-squared structures can be so complex as to make risk assessment difficult. By modeling a simplified CDO-squared structure using Monte Carlo simulation, two of the risks unique to such structures are examined: default location risk and overlap risk. Failure to take account of these risks during a distressed credit environment will result in greater than anticipated losses among senior CDO-squared tranches.

Keywords : collateralized debt obligation; CDO-squared; default location risk; overlap risk; Monte Carlo simulation
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