On the valuation of cashflow CSOs without Monte Carlo simulation.

Abstract

The most common method of pricing a cashflow collateralized debt obligation (cashflow CDO) is to use Monte Carlo integration. However, Monte Carlo integration is computationally intensive and often faster methods of pricing are required. Gallagher et al. (2009) proposed a semi-analytic approximation that allows fast pricing of cashflow CDOs.This thesis has two goals: (i) A self contained description of the mathematical background necessary for practical implementations of cash ow CDO pricing and (ii) a critical examination of the semi-analytic cashflow CDO pricing method proposed by Gallagher et al. (2009). We examine one of the main arguments in their paper surrounding the modality of the underlying probability distribution and suggest an alternative explanation for the accuracy of their method. With this new understanding, we describe the conditions under which the approximation will be most accurate.