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Loan securitisation: default term structure and asset pricing based on loss prioritisation

Jobst, Andreas A. (2002) Loan securitisation: default term structure and asset pricing based on loss prioritisation. Discussion paper, 422. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Abstract

Ambivalence in the regulatory definition of capital adequacy for credit risk has recently stirred the financial services industry to collateral loan obligations (CLOs) as an important balance sheet management tool. CLOs represent a specialised form of Asset-Backed Securitisation (ABS), with investors acquiring a structured claim on the interest proceeds generated from a portfolio of bank loans in the form of tranches with different seniority. By way of modelling Merton-type risk-neutral asset returns of contingent claims on a multi-asset portfolio of corporate loans in a CLO transaction, we analyse the optimal design of loan securitisation from the perspective of credit risk in potential collateral default. We propose a pricing model that draws on a careful simulation of expected loan loss based on parametric bootstrapping through extreme value theory (EVT). The analysis illustrates the dichotomous effect of loss cascading, as the most junior tranche of CLO transactions exhibits a distinctly different default tolerance compared to the remaining tranches. By solving the puzzling question of properly pricing the risk premium for expected credit loss, we explain the rationale of first loss retention as credit risk cover on the basis of our simulation results for pricing purposes under the impact of asymmetric information.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2002 The Author
Library of Congress subject classification: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems
D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information
G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation
G - Financial Economics > G2 - Financial Institutions and Services > G20 - General
C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods: General > C15 - Statistical Simulation Methods; Monte Carlo Methods; Bootstrap Methods
G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing; Futures Pricing
C - Mathematical and Quantitative Methods > C2 - Econometric Methods: Single Equation Models; Single Variables > C22 - Time-Series Models
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 422
Date Deposited: 20 Aug 2009 13:17
URL: http://eprints.lse.ac.uk/24941/

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