Working Paper: NBER ID: w22723
Authors: Sang Byung Seo; Jessica A. Wachter
Abstract: We investigate whether a model with a time-varying probability of economic disaster can explain the pricing of collateralized debt obligations, both prior to and during the 2008-2009 financial crisis. Namely, we examine the pricing of tranches on the CDX, an index of credit default swaps on large investment-grade firms. CDX senior tranches are essentially deep out-of-the money put options because they do not incur losses until a large fraction of previously stable firms default. As such, these products clearly reflect the market’s assessment of rare-event risk. We find that the model can simultaneously explain prices on CDX senior tranches and on equity index options at parameter values that are consistent with the equity premium and with aggregate stock market volatility. Our results demonstrate the importance of beliefs about rare disasters for asset prices, even during periods of relative economic stability.
Keywords: Collateralized Debt Obligations; Financial Crisis; Rare Events; Asset Pricing
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| implied disaster probabilities derived from option prices (G13) | pricing of CDOs (G19) |
| beliefs about rare disasters (H84) | asset prices (G19) |
| risk perceptions (D81) | pricing of CDO senior tranches (G19) |
| low perceived risk of disaster (H84) | low spreads on CDO senior tranches (G19) |
| heightened fears of economic catastrophe (E32) | high spreads on CDO senior tranches (G19) |
| disaster probabilities inferred from option prices (G13) | pricing dynamics of CDOs (G19) |