Simulation methods for risk analysis of collateralized debt obligations

Collateralized debt obligations (CDOs) are sophisticated financial products that offer a range of investments, known as tranches, at varying risk levels backed by a collateral pool typically consisting of corporate debt (bonds, loans, default swaps, etc.). The analysis of the risk-return properties of CDO tranches is complicated by the highly non-linear and time dependent relationship between the cash flows to the tranche and the underlying collateral performance. This paper describes a multiple time step simulation approach that tracks cash flows over the life of a CDO deal to determine the risk characteristics of CDO tranches.