Part 15 - CDS Flashcards
How do we price default risk?
We price default risk by considering the credit rating of the borrower and the credit spread, the difference between the borrower’s interest rate and a risk-free rate. Higher risk borrowers with lower credit ratings will have wider credit spreads.
How is a CDO structured and what matters for pricing?
A collateralized debt obligation (CDO) is structured into tranches, like slices of a pie. These tranches have varying levels of seniority, meaning some get paid back before others in case of defaults. The pricing of these tranches depends on how correlated the underlying assets are. If the assets are highly correlated, meaning they tend to default together, all the tranches in the CDO become riskier and their price goes down.
