Valuing CDOs with the Gaussian Copula – What Went Wrong?

Gunter Meissner

“Take risks: if you win, you will be happy; if you lose, you will be wise”

– author unknown

When the global financial crisis hit from 2007 to 2009, the Gaussian copula was widely blamed for the crisis, especially when applied to valuing collateralised debt obligations (CDOs).11 See “Recipe for Disaster: The Formula that killed Wall Street”, Wired (2009); “Wall Street Wizards Forgot a Few Variables”, New York Times (2009); “The formula that felled Wall Street”, Financial Times (2009). In this chapter we analyse the pricing methodology of CDOs and evaluate whether the Gaussian copula is to blame. Let’s first look at some CDO basics.

CDO BASICS – WHAT IS A CDO? WHY CDOS? TYPES OF CDOS What is a CDO?

A CDO (collateralised debt obligation) is a financial structure in which the credit risk from a pool of securities is transferred from one counterparty, the originating bank, to another, the investor. The investor can invest money in different CDO tranches. Each tranche has a different degree of credit risk. The credit risk is distributed with a waterfall principle: if losses accumulate and the detachment level of a tranche is breached, additional credit losses flow into the

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