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Financial Risk Management of Insurance Enterprises

Financial Risk Management of Insurance Enterprises. Collateralized Debt Obligations (CDOs). Overview. Introduction History Fundamentals Attributes Parties Credit Ratings Synthetic CDOs Valuation models Current events. Introduction of CDOs. Asset-backed security

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Financial Risk Management of Insurance Enterprises

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  1. Financial Risk Management of Insurance Enterprises Collateralized Debt Obligations (CDOs)

  2. Overview • Introduction • History • Fundamentals • Attributes • Parties • Credit Ratings • Synthetic CDOs • Valuation models • Current events

  3. Introduction of CDOs • Asset-backed security • Structured credit product • Portfolio of fixed-income assets • Tranches

  4. History • First CDOs, 1987 • High yield bond portfolios • Next CDOs, 1989 • Mortgage Backed Securities • John Meriwether, Salomon Brothers • Liar’s Poker • Long Term Capital Management • Credit Risk Transfer (CRT) vehicles • Loans • Securitization • CDOs Growth • Synthetic CDOs

  5. Fundamental Concepts behind CDOs • Corporate entity raises capital • Invests in financial assets • Distributes cash flows

  6. Four Key Attributes of CDOs • Assets • Liabilities • Purposes • Credit Structure

  7. Assets • Corporate bonds • Residential Mortgage-Backed Securities • Commercial Mortgage-Backed Securities • Asset-backed Securities

  8. Liabilities • Senior debt • Junior debt • Subordinated debt • Equity

  9. Purposes • Balance sheet • Shrink balance sheet • Reduce required regulatory capital • Lower funding costs • Arbitrage • Asset manager increases fund size and fees • Origination • Issuing securities to CDO as CDO issues liabilities

  10. Structure • Market value CDOs • Enhance returns through trading • Credit quality derives from the ability to liquidate assets and repay debt tranches • Cash flow CDOs • Cash flows from assets pays the interest and principal of tranches

  11. Cash Flow CDOs • Distribution of cash flows: waterfall • Coverage test • Overcollateralization • Interest coverage

  12. Structural Matrix

  13. Parties • Asset managers • Asset sellers • Investment bankers and structurers • Monoline bond insurers and financial guarantors

  14. Credit Ratings • Collateral diversification • Likelihood of default • Recovery rates

  15. Synthetic CDOs • Does not own assets on which it bears the credit risk • Sells protection via Credit Default Swaps • Buys protection via tranches issued

  16. Valuation models • Gaussian copula model • Default correlation • Dynamic model • Hazard rates with deterministic drift with periodic impulses

  17. CDOs on CDOs • CDOs based on a tranche from a CDO • Example: • CDO^2 based on a tranche (e.g. BBB) of a CDO • CDO^n based on a tranche of a CDO^(n-1) • It gets very complicated very quickly

  18. Current events • Subprime mortgage crisis • Counterparty credit risk • Liquidity issues • Prices drops • ABX index • Rating agencies are blamed for inaccurate credit ratings

  19. Concerns with CRT vehicles • ‘Clean’ risk transfer • Risk of failure of market participants to understand associated risk • Potentially high concentration of risk • Adverse selection

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