Pricing CDOs with counterparty risk

lhjensen · October 7th, 2008, 10:29 am

Should one include counterparty risk (eg. Lehmans default) when pricing syntethic CDOs?Any thoughts on how to do this? Any useful articles?I was thinking something like including the CDS of the counterparty into the pool.

katastrofa · October 9th, 2008, 2:43 am

Multiply the payments by the implied survival probability of the counterparty.

Paul · October 9th, 2008, 5:08 am

katastrofa, that method is soooooo last year!P

lhjensen · October 9th, 2008, 6:33 am

Then what about correlation between the counterpart and the pool?

katastrofa · October 9th, 2008, 6:00 pm

In a [forbidden word] copula model, you can do the multiplication on the level of conditional probabilities, which will corellate the countrparty and the basket.

Structurer · October 9th, 2008, 6:50 pm

aren't you trading under a collateralised ISDA?

Yossarian22 · October 11th, 2008, 11:49 pm

How about just buying protection on the counterparty?

katastrofa · October 12th, 2008, 9:26 am

QuoteOriginally posted by: Yossarian22How about just buying protection on the counterparty?The problem is, you are hedging an unknown profit, because you don't know how much will the counterparty owe you. To match expected profit from the CDO tranche with the expected payout from the CDS, you need to correlate defaults in the CDO basket with the counterparty's default.