The Effects of Asset Correlation on CDO Tranches in Taiwan

Recently the Collateralized Debt Obligations (CDO) started actively trading in Taiwan, exhibiting impressive growth over last few years. This paper presents the structure, rating methodologies and risks of CDO, especially focuses on the developing environments in domestic CDO market.
Asset Correlation is the key factor to the ratings of CDO. In this paper we briefly introduce to some of the CDO rating models using by the primary credit risk rating agencies. Then we make use of the Default VECTOR model published by Fitch Ratings to investigate the effects of asset correlation in CDO tranches.
Consequently, we will show that correlation can be either positive or negative, depending on which part of the CDO tranches is concerned. When the asset pool is highly correlated, most of the assets in the pool will be expected to default or not to default all together. Then for equity tranche investors the probability of default in CDO would be lower, so they prefer the higher asset correlation in CDO. As for senior tranches investors, they prefer lower correlation because it means the defaults in the asset pool take place individually and the loss will be absorbed first by the equity tranche and mezzanine.