Pricing Structured Products with Economic Covariates

Abstract

We introduce a top-down no-arbitrage model for pricing structured products. The losses are described by Cox processes whose intensities depend on economic variables. The model provides economic insight into the impact of structured products on the risk exposure of financial institutions and systemic risk. We estimate the model using CDO data and find that spreads decrease with higher interest rates, and increase with volatility and leverage. Volatility is the primary determinant of variation in tranche spreads, but leverage and interest rates are more closely associated with rare credit events. Model-implied risk premiums and the probabilities of tranche losses increase substantially during the financial crisis.

Keywords: structured product, collateralized debt obligation, tranche pricing, economic determinants, risk premiums

JEL Classification: G12