Kamakura Releases Study: How Conventional CDO Analytics Missed the Mark
HONOLULU, December 20, 2007: Kamakura Corporation released a study today demonstrating that conventional analysis of CDO tranches values was consistently more optimistic in valuation than a simulation which correctly incorporates business-cycle driven defaults in valuation. The paper, with Kamakura Managing Director of Research Professor Robert Jarrow as lead author, shows that the commonly used "copula" approach leads to incorrect valuations due to a number of critical simplifying assumptions. The study, titled "CDO Valuation: Fact and Fiction," points out three critical simplifications that cause errors when using the copula approach: a single period modeling horizon, constant default probabilities, and highly simplified assumptions about the nature of correlation in default events. The analysis relies on simulations of up to 10 million scenarios using the multiple models approach embedded in the Kamakura web-based CDO valuation tool KRIS-CDO. Kamakura founder Dr. Donald R. van Deventer and Managing Directors Ms. Li Li and Mark Mesler joined Professor Jarrow in co-authoring the study.
"Two years ago the Wall Street Journal in a page 1 story pointed out the dangers in relying on the copula approach for CDO valuation, but investors were slow to realize the magnitude of their model risk," said Warren Sherman, Kamakura President and Chief Operating Officer. "The credit events of the last six months make it more obvious that macro-economic factors like home prices and interest rates are critical drivers of correlated defaults in a world where default probabilities rise and fall. This study shows that the copula approach dramatically overstates the value of CDO tranches compared to a reduced form model approach where the business cycle is correctly modeled. The authors performed credit portfolio simulations using more than 25 different approaches and conclude that very large model risk is fundamental to the nature of the CDO structure. They conclude that 6 to 11 million scenarios are necessary to have a high degree of confidence that CDO valuation is within the typical bid-offered spread seen in more conventional markets."
Kamakura noted that all simulations were done using the same reference collateral, a five year horizon modeled as 60 monthly periods, and using the same starting default probabilities in each case. The initial inspiration for the study was a presentation done by Michel Araten at the ICBI Risk Minds Convention in Geneva in December 2006. Earlier versions of the study were reviewed at the International Association of Credit Portfolio Managers meeting in Zurich in June 2007 and at the University of Chicago Credit Conference in October 2007. A copy of the study can be obtained by contacting Mr. Warren Sherman at 1-201-600-7542. Kamakura has been an active advisor to investors holding mortgage backed securities, collateralized debt obligations, and asset-backed commercial paper that has been affected by the credit crisis.
About Kamakura Corporation
Kamakura Corporation is a leading provider of risk management information, processing and software. Kamakura has been a provider of daily default probabilities and default correlations for listed companies since November, 2002. Kamakura launched its business mortality model for unlisted companies in January 2004. Kamakura is also the first company in the world to develop and install a fully integrated enterprise risk management system that analyzes credit risk, market risk, asset and liability management, and transfer pricing software system. Kamakura has served more than 160 clients ranging in size from $3 billion in assets to $1.6 trillion in assets. Kamakura's risk management products are currently used in 23 countries, including the United States, Canada, Germany, the Netherlands, France, Switzerland, the United Kingdom, Eastern Europe, the Middle East, Africa, Australia, Japan, China, Korea and many other countries in Asia.
Kamakura's research effort is led by Professor Robert Jarrow, who was named Financial Engineer of the Year in 1997 by the International Association of Financial Engineers. Professor Jarrow and Dr. van Deventer were both named to the 50 member RISK Hall of Fame in December 2002. Kamakura management has published more than 100 publications on credit risk, market risk, and asset and liability management.
Kamakura has world-wide distribution alliances with Fiserv and Unisys, making Kamakura products available in almost every major city around the globe.
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