From insurance risk to credit portfolio management: a new approach to pricing CDOs. Issue 10 (2nd October 2016)

• Record Type: Journal Article
• Authors: Andreoli, Alessandro; Ballestra, Luca Vincenzo; Pacelli, Graziella
• Is Part Of: Quantitative finance. Volume 16:Issue 10(2016)
• Page Start: 1495
• Page End: 1510
• Publication Date: 2016-10-02
• Subjects: Collateralized debt obligation -- CDO -- Incomplete market -- Sharpe ratio -- Bid-ask spread -- Finite difference; C02 -- C63 -- G13; Finance -- Periodicals; Business mathematics -- Periodicals; Finance -- Mathematical models -- Periodicals; Investments -- Mathematics -- Periodicals; Economics -- Periodicals; Finances -- Modèles mathématiques -- Périodiques; 332.015118
• DOI: 10.1080/14697688.2015.1136076
• Languages: English
• ISSNs: 1469-7688

Abstract

Abstract : We present a new approach for pricing collateralized debt obligations (CDOs) which takes into account the issue of the market incompleteness. In particular, we develop a suitable extension of the actuarial framework proposed by Bayraktar et al. [Valuation of mortality risk via the instantaneous Sharpe ratio: Applications to life annuities. J. Econ. Dyn. Control, 2009, 33, 676–691], Milevsky et al. [Financial valuation of mortality risk via the instantaneous Sharpe-ratio: Applications to pricing pure endowments. Working Paper, 2007. Available at:http://arxiv.org/abs/0705.1302 ], Young [Pricing life insurance under stochastic mortality via the instantaneous Sharpe ratio: Theorems and proofs. Technical Report, 2007. Available at:http://arxiv.org/abs/0705.1297 ] and Young [Pricing life insurance under stochastic mortality via the instantaneous Sharpe ratio. Insurance: Math. Econ., 2008, 42, 691–703], which is based on the so-called instantaneous Sharpe ratio. Such a procedure allows us to incorporate the attitude of investors towards risk in a direct and rational way and, in addition, is also suitable for dealing with the often illiquid CDO market. Numerical experiments are presented which reveal that the market incompleteness can have a strong effect on the pricing of CDOs, and allows us to explain the high bid-ask spreads that are frequently observed in the markets.