From insurance risk to credit portfolio management: a new approach to pricing CDOs |
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Authors: | Alessandro Andreoli Luca Vincenzo Ballestra |
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Affiliation: | 1. Dipartimento di Management, Università Politecnica delle Marche, Piazza Martelli 8, 60121Ancona, Italy.;2. Dipartimento di Economia, Seconda Università di Napoli, Corso Gran Priorato di Malta, 81043Capua, Italy. |
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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. |
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Keywords: | Collateralized debt obligation CDO Incomplete market Sharpe ratio Bid-ask spread Finite difference |
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