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How does the market value complex structured-credit securities? This issue is central to understanding the current financial crisis and identifying effective policy measures. The authors study this issue from a novel perspective by contrasting the valuation of CDO equity with that of bank stocks. This is possible because both CDO equity and bank stock represent levered first-loss residual claims on an underlying portfolio of debt. There are strong similarities in the two types of equity investments. Using an extensive data set of CDX index tranche prices, they find that the discount rates applied by the market to bank and CDO equity are very comparable.
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