CPDO instruments - analysis and pricing

Abstract

CPDO (Constant Proportion Debt Obligation) products are seen as miracles of structured credit. They are AAA rated by Moody's and are able to offer returns of LlBOR + 200 bps. The reason for this is a combination of some intelligent rebalancing of the portfolio combined with reduced direct correlation exposure. This project examines the structure of CPDO products and tries to analyze and predict their performance in the market. A path dependent Monte Carlo simulation has been created in VBA for this purpose. The project also aims to clarify and suggest an effective pricing and investment strategy for the financial institutions selling this product. We have modeled many futurestress scenarios and identified the risk elements of this product in those scenarios and identified vulnerabilities. A comparison with existing CPPl (Constant Proportion Portfolio Insurance) products is also performed, since CPDOs evolved from CPPls yet have quite different risk-return characteristics. We have determined that CPDOs can be relatively low risk only if one, they are structured properly so as to take on the right amount of risk and two, the credit market doesn't suffer a serious downturn. There are also rating issues because of inadequate product understanding by the rating agencies. CPDOs are bearing the brunt of the credit market downturns due to inherent limitations in their structure.