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Pricing Tranches on the Credit Default Swap Index * Andrew Carverhill Dan Luo September 20, 2018 ABSTRACT This paper studies the pricing in the Credit Default Swap Index (CDX) tranche market. We first design an efficient procedure to value tranches using an intensity- based model which falls into the affine model class. The CDX tranche spreads are effectively explained by a three-factor version of this model, both before and during the financial crisis of 2008. We then construct tradable tranche portfolios to represent the intensity factors. We compare the pricing of the tranches, equity derivatives and equities by regressing the CDX portfolios against the equity index, the volatility factor, and the smirk factor, the three extracted from the index option returns, and against the standard Fama-French market, size, and book-to-market factors. Our results show that the tranche spreads do not offer returns in excess of the common risk compensations in the equity and derivatives markets. JEL Classification: G11, G12, G13. Keywords: CDX index, tranches, index options, option smirk, market integration. * We thank Bart Lambrecht, Jun Pan, Stephen Taylor, Neng Wang, Hong Yan, and seminar audi- ences at FMA 2011, CICF 2011, the University of Hong Kong, and Shanghai University of Finance and Economics for their valuable suggestions and comments. Department of Economics and Finance, City University of Hong Kong, Tat Chee Avenue, Kowloon, Hong Kong, China SAR. Email: [email protected]. School of Finance, Shanghai University of Finance and Economics, 777 Guoding Road, Shang- hai 200433, China, and Shanghai Key Laboratory of Financial Information Technology, Shanghai 200433,China. Email: [email protected].
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Page 1: Pricing Tranches on the Credit Default Swap Index Tranches on the Credit Default Swap... · hedging corresponds to a signi cant regression coe cient. However, if the residual return

Pricing Tranches on the Credit Default Swap Index∗

Andrew Carverhill† Dan Luo‡

September 20, 2018

ABSTRACT

This paper studies the pricing in the Credit Default Swap Index (CDX) tranchemarket. We first design an efficient procedure to value tranches using an intensity-based model which falls into the affine model class. The CDX tranche spreadsare effectively explained by a three-factor version of this model, both before andduring the financial crisis of 2008. We then construct tradable tranche portfoliosto represent the intensity factors. We compare the pricing of the tranches, equityderivatives and equities by regressing the CDX portfolios against the equity index,the volatility factor, and the smirk factor, the three extracted from the index optionreturns, and against the standard Fama-French market, size, and book-to-marketfactors. Our results show that the tranche spreads do not offer returns in excess ofthe common risk compensations in the equity and derivatives markets.

JEL Classification: G11, G12, G13.Keywords: CDX index, tranches, index options, option smirk, market integration.

∗We thank Bart Lambrecht, Jun Pan, Stephen Taylor, Neng Wang, Hong Yan, and seminar audi-ences at FMA 2011, CICF 2011, the University of Hong Kong, and Shanghai University of Finance andEconomics for their valuable suggestions and comments.†Department of Economics and Finance, City University of Hong Kong, Tat Chee Avenue, Kowloon,

Hong Kong, China SAR. Email: [email protected].‡School of Finance, Shanghai University of Finance and Economics, 777 Guoding Road, Shang-

hai 200433, China, and Shanghai Key Laboratory of Financial Information Technology, Shanghai200433,China. Email: [email protected].

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1. Introduction

The Financial Crisis of 2008 has been widely attributed to the explosion in the use of

credit derivatives. Can such instruments be accurately priced? Have the actual market

prices or associated spread quotations have been reasonable? These questions have been

intensively studied, notably in contributions of Coval, Jurek, and Stafford (CJS 2009a)

and Collin-Dufrese, Goldstein, and Yang (CDGY 2010). CJS make the point that the

senior CDO tranche is exposed to market-wide catastrophic default risk, and that the

S&P 500 index options are exposed to the same risk. Based on this insight, they price

the CDX tranches using the pricing kernel inferred from the index options, and assuming

that the correlation among asset dynamics in the CDX underlying portfolio is constant

across firms, and driven by the market return. They conclude that spreads on the senior

CDX tranches are too low to compensate the systematic risk they are bearing1, if this risk

is priced using the index options. CDGY argue that the CJS’s copula type CDO pricing

model is not flexible enough to capture firms’ joint default dynamics. They provide a fully

dynamic and integrated model for both the market and each individual firm. Fitting this

model to the CDX and index options data, they find no evidence of market segmentation

either before or during the financial crisis period.2

In this paper, we first implement an efficient CDO pricing procedure, based on the

model of Longstaff and Rajan (LR 2008). This model can encompass a number of factors

representing default intensities, and as do LR, we implement it for three factors. We

also design an efficient procedure to evaluate the model, exploiting its affine structure,

as in Duffie, Pan, and Singleton (DPS 2000). We fit the model to the well established

spread quotations of the CDO tranches associated with the standard CDX credit index,

using the Monte Carlo Expectation Maximization algorithm of Duffie, Eckner, Horel,

and Saita (DEHS 2009). This algorithm is hybrid, efficiently combining a maximum

likelihood estimation of the model parameters, and a Bayesian filtration of the latent

default intensity factors.

The LR Model that we implement, is of reduced-form type, and directly models losses

to the underlying portfolio of a CDO. Total loss on the portfolio is assumed to be driven

by a single or multiple risk factor(s). A three-factor version of this model fits the actual

CDX tranche spreads to high precision, with pricing errors typically around several basis

1See CJS Table VI. Except for the junior 0-3 tranche, the average model implied spreads are 2-5 timesas large as actual spreads for all other tranches.

2Li and Zhao (2012) also study the modeling and efficiency of CDX tranche prices. These authorsdirectly modify the model of CJS, so that it can price the price the CDX tranches and index optionsaccurately and simultaneously. Their conclusion agrees with that of CDGY and the present paper, thatthe CDX tranches and option prices are integrated.

1

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points. By contrast, the model of Duffie and Garleanu (2001), begins by modeling the

dynamics of each underlying firm, and then aggregates over the portfolio to characterize

the joint default behavior. Default intensity of a firm, in this model, consists of an

idiosyncratic component, as well as broader sectoral, regional and global components, and

default arrivals are assumed to be independent, conditioned on the intensity processes.

Feldhutter (2008) fits this model to the CDX tranche spreads and concludes that the

model exhibits too little variation in the senior tranches, although it matches the average

spreads well.

After fitting the LR Model, we then apply it to investigating the CDX market itself.

LR note that the three default intensity factors can be interpreted as representing single

firm default, default of a number of firms together, and market-wide catastrophic default,

respectively, and the CDO spreads give the prices of insuring against such types of default.

Have these prices been reasonable, in the crisis period, and is there evidence that the CDX

market has been segmented away from the rest of the capital market? In particular, have

the writers of these instruments set the prices in their own favor?

We address this issue raised in CJS and CDGY, however, following a less structural

approach, similar to that of Fama and French (1993; 1996). Our approach is to construct

portfolios representing our three CDO factors, and to see, using OLS regression, whether

the returns of these can be explained/hedged using established market factors. Successful

hedging corresponds to a significant regression coefficient. However, if the residual return

is significant, revealed by the t-statistic on the unit constant in the regression, then we

conclude that the market factors have not accounted for all the priced sources of risk in

the CDO spreads.

We first test our CDO factor portfolios against three factors extracted using Principal

Components Analysis, from the S&P 500 index option returns. We refer to these as the

market, the volatility, and the smirk factors, and they represent an overwhelming fraction

of the option price dynamics. The market factor here is essentially just the market index

itself, and the volatility factor is essentially the same as that in Coval and Shumway

(2001) and Bakshi and Kapadia (2003). The smirk factor broadly represents the return

from being short OTM puts and long OTM calls, and it can be interpreted in terms of

the price of insurance against market wide losses. This factor was analyzed for the S&P

500 futures options by Carverhill, Cheuk, and Dyrting (2009). CJS are using the options

smirk to infer the price of market-catastrophe risk in their CDO pricing procedure.3

We then test our CDO factor portfolios against the Fama-French equity portfolios,

3The options smirk is the stylized fact that out of the money (OTM) puts have a higher impliedvolatility than the OTM calls. Intuitively, this reflects demand for insurance against falls in the equityindex, that OTM puts can provide.

2

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representing the Market, size effect (small minus big - SMB), and book to market effect

(high minus low - HML).

The results are as follows: Our CDO factor portfolios experience high returns at the

onset of the Financial Crisis in September 2007, and the junior tranche also has high

return in May 2005, coinciding with the GM crisis. Testing the factors against the option

factors, we see that they are all negatively exposed to the market factor, as expected. Also,

consistent with CJS, the senior tranche is exposed to the smirk factor. Having hedged all

the options factors, there is a residual Sharpe ratio for the first (junior tranche) factor,

but not the other factors. Our results suggest that the senior tranche factor is integrated

with the options market factors, agreeing with CDGY, but that the junior factor also

involves other priced factors.

Testing against the Fama-French factors, the Market factor is again significant. But

the only other significant factor is the HML factor, which is significant for the junior CDO

tranche factor. The junior trance factor is partially explained in terms of established

factors, but the R2 is still only 13%, and there is a residual Sharpe ratio, indicating that

there must be other priced factors for the junior tranche factor.

Our contribution to the literature is first that we provide a semi-closed form solution to

the “top-down” basket credit risk modeling approach. By fitting the model to the actual

CDX tranche spread quotations, we find that the spreads can be efficiently explained

by three default intensity factors, before and during the crisis period. For recent works

on a similar motif, Choi, Doshi, Jacobs, and Turnbull (2016) introduce a top-down no-

arbitrage model with economic variables. Feldhutter and Nielsen (2012) use MCMC for

CDO valuation. And Longstaff and Myers (2014) investigate the equity tranche of a CDO.

Second, we provide a method to construct tradable portfolios of assets to represent risk

factors, and applied to the credit and equity derivatives explored in this study. Finally, we

provide evidence that the CDX tranches are integrated with the equity and its derivatives

markets.

The remainder of this paper is organized as follows. Section II gives a brief intro-

duction to CDOs and presents our CDO pricing model. Section III describes the data

used in the study and reports the empirical results of the pricing of the CDX tranches.

Section IV examines the integration of the CDX tranches in the financial market. We

also illustrate how to construct CDX tranche portfolios to represent the default intensity

factors. Summary of the results and concluding remarks are provided in Section V.

3

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2. Modeling CDO tranches

In this section we first describe the pooling and tranching process to get CDOs. We

then design a procedure to value CDO tranches in a reduced-form intensity-based model

framework. We finally derive our econometric method to fit the CDO pricing model to

the CDO tranche spread quotations observed in the market.

2.1. An Introduction to CDOs

A stylized cash CDO is a tranched structure of claims against a portfolio of underlying

names, which are cash assets such as loans, corporate bonds, asset-backed securities,

mortgage-backed securities, etc. The assets are pooled together and the tranches are

issued against them. The tranches have prioritized claims to the cash flows generated by

the pool. A CDO tranche can be characterized by its attachment point and detachment

point. A M -N (M<N) tranche assumes N−M percent of the notional value of the

CDO and suffers loss of principal when the underlying portfolio default loss exceeds the

attachment point M%. The tranche principal is reduced linearly with total portfolio loss

between M% and N%. The tranche is wiped out if the portfolio loss goes beyond the

detachment point N%. A tranche investor is paid a running spread on the remaining

principal of that tranche, in return for bearing possible losses due to defaults among the

names.

The junior tranche, which takes the first several percent of default loss, gets eroded

easily. However, the senior tranche should be quite safe since it will not be touched until

all the subordinated tranches are completely absorbed by defaults. Due to the cushion

provided by the junior and mezzanine tranches, the senior tranche usually attains an AAA

credit rating even though the underlying collateral pool could be rated BBB on average.

Accordingly, the spreads paid by the tranches decrease from junior tranche to mezzanine

and to senior tranches. CDOs serve to complete the financial market by providing high

credit quality securities which are in demand by particular institutional investors, who

are restricted to buy only highly-rated securities.

A synthetic CDO differs from a cash CDO in that it gains credit exposures to the names

through credit default swaps (CDSs) rather than physically purchasing a portfolio of cash

assets. A CDS buyer, also the protection buyer, makes a quarterly premium payment on

the notional value of the CDS contract to the CDS writer, also the protection seller, till

the maturity of the contract, or a credit event which happens to the reference entity of

the contract, whichever comes first.4 The reference entity is usually not a counterparty of

4In addition to bankruptcy, credit events often include failure to pay, obligation acceleration, repudi-

4

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the contract. When a credit event occurs within the maturity of the CDS, the protection

seller is obliged to make a payoff to the protection buyer, by purchasing the referred bond

or loan at par in a physical settlement or paying the difference between the par value and

the market value of the bond or loan in a cash settlement. The writer of a CDS contract

is the seller of default risk similar to the buyer of the bond referred by the CDS. The CDS

market is more liquid than the bond market and the tax effect has minimum influence on

the CDS pricing.

2.2. Analyzing CDO Tranches Using LR Model in DPS Framework

LR adopt a “top-down” approach to model portfolio credit risk. Since the total portfolio

default loss provides a sufficient statistic to value the CDO tranche payoff, LR directly

make assumptions on the total portfolio loss, rather than modeling the dynamics of each

firm and then aggregating over the portfolio. Equivalently, we conduct our analysis on

the portfolio principal remaining per $1 notional amount, denoted by Lt. We assume

Lt = eZ1eZ2eZ3 , (1)

where Zi is a compound Poisson jump process with stochastic jump intensity λi and jump

size γi exponentially distributed with mean −γi (γi > 0), i = 1, 2, 3; Z1, Z2 and Z3 are

independent of one another.5

Write the logarithm of Lt as lt, that is, lt = ln(Lt), then

dlt = dZ1 + dZ2 + dZ3. (2)

To ensure nonnegativity, the default intensities are assumed to follow CIR processes,

dλ1t = (a1 − b1λ1t)dt+ σ1√λ1tdW1t, (3)

dλ2t = (a2 − b2λ2t)dt+ σ2√λ2tdW2t, (4)

dλ3t = (a3 − b3λ3t)dt+ σ3√λ3tdW3t, (5)

where W1t, W2t, and W3t are standard independent Brownian motions.

All the above dynamics are given under the risk neutral measure (Q measure). To

put the pricing model into the DPS framework, we rewrite the model in state space form.

ation or moratorium, restructuring, downgrade, merger, war, etc.5LR made the assumption of constant jump size γ1, γ2 and γ3. However, exponentially distributed

jump sizes seem more plausible as loss-given-default is uncertain at default. Most importantly, we canavoid the problem caused by discrete distribution of Lt under constant jump sizes. Specifically, theFourier transform in DPS is hard to implement for a discrete distribution function.

5

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The state variable is now

Xt = (λ1t, λ2t, λ3t, lt). (6)

State equations are Eq. 2, Eq. 3, Eq. 4, and Eq. 5. We further assume that the discount

rate rt is constant hence does not depend on the state variable Xt. This model falls into

the Affine class of DPS. According to DPS, a European call option with option underlying

Lt = ed·Xt (d = (0, 0, 0, 1) in our model), strike price c and time to maturity T can be

valued by the following formula.

C(d, c, T, χ) = Gd,−d(− ln(c);X0, T, χ)− cG0,−d(− ln(c);X0, T, χ), (7)

Ga,b(y;X0, T, χ) =ψχ(a,X0, 0, T )

2− 1

π

∫∞0

Im[ψχ(a+ jbv,X0, 0, T )e−jvy]

vdv, (8)

ψχ(u, x, t, T ) = eα(t)+β(t)·x, (9)

where χ is the vector which stacks the parameters governing the dynamics of the state

variable; Im denotes the imaginary part of a complex number; j stands for the unit

imaginary number. Also α(t) and β(t) satisfy the following Ricatti equations

βi(t) = −1

2σ2i β

2i (t) + biβi(t)− (

1

1 + γiβ4(t)− 1), i = 1, 2, 3, (10)

β4(t) = 1− jv or 0− jv, (11)

α(t) = rt −3∑i=1

aiβi(t), (12)

with boundary conditions β(T ) = u and α(T ) = 0. These equations can be solved

analytically or by numerical methods such as Runge-Kutta. The method provided in Pan

(2002) can be applied to control for discretization errors and truncation errors when we

implement the inversion formula in Eq. 8. To facilitate computation, we re-evaluate α

and β only when the parameters are changed.

It is now straightforward to value CDO tranches with cash flow tied to the underlying

portfolio remaining principal. Denote as LAB(t) the principal remaining of the tranche

with attachment point 1− A and detachment point 1−B and A > B. Then,

LAB(t) = maxL(t)−B, 0 −maxL(t)− A, 0. (13)

Let CDODAB(t) and CDOP

AB(t) be the value of the default leg and premium (protection)

6

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leg of the tranche at time t, respectively. The default leg of the tranche can be valued as

CDODAB(t) = −Et

[∫ TtP st dLAB(s)

]= −Et

[P st LAB(s)

]Tt

−∫ T

t

∂P st

∂sLAB(s)ds

= −P T

t Et[LAB(T )] + LAB(t)− rt∫ TtP st Et[LAB(s)]ds, (14)

where T is the maturity time of the CDO; P st = e−

∫ st rsds is the discount factor; Et

denotes taking expectation under the risk neutral measure conditional on the information

available at time t. The second equality is attained by applying integration by parts to

the Riemann-Stieltjes type integral in the first equation. The third equality assumes that

rt remains constant in time period t to T . LAB(t) can be evaluated by Eq. 13 since L(t)

is known at time t.

The premium leg of the tranche can be valued as

CDOPAB(t) = s

AB

∫ TtP st Et[LAB(s)]ds, (15)

where sAB

is the spread paid for the remaining principal of the tranche.

By Eq. 13, Et[P st LAB(s)] (t ≤ s ≤ T ) can be regarded as the difference between

the value of two call options written on the same underlying Lt, with the same time to

maturity s − t, but distinct strike prices B and A. According to the analysis above, the

value of each call option can be achieved analytically to the extent of an inverse Fourier

transform. For s ∈ [t, T ],

Et[P st LAB(s)] =

1

2ψχ(d,Xt, t, s)−

1

π

∫ ∞v=0

Im[ψχ(d− jvd,Xt, t, s)ejv ln(B)]

vdv

−B[

1

2ψχ(0, Xt, t, s)−

1

π

∫ ∞v=0

Im[ψχ(0− jvd,Xt, t, s)ejv ln(B)]

vdv

]−1

2ψχ(d,Xt, t, s) +

1

π

∫ ∞v=0

Im[ψχ(d− jvd,Xt, t, s)ejv ln(A)]

vdv

+A

[1

2ψχ(0, Xt, t, s)−

1

π

∫ ∞v=0

Im[ψχ(0− jvd,Xt, t, s)ejv ln(A)]

vdv

], (16)

where ψχ(·) is as defined in Eq. 9. We can do the following to further facilitate computa-

tion based on the above formula.

1. The call options differ only in the strike prices. Therefore, we just need to calculate

ψχ(d− jvd,Xt, t, s) and ψχ(0− jvd,Xt, t, s) once to simultaneously give all option

values with distinct strike prices.

7

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2. ψχ(d − jvd,Xt, t, s) and ψχ(0 − jvd,Xt, t, s) are smooth functions of v. We can

calculate ψ for a coarse partition of v and then interpolate for a finer partition when

integrating with respect to v.

3. Likewise, Et[P st LAB(s)] is a smooth function of s. To calculate

∫ TtEt[P s

t LAB(s)]ds,

we choose a coarse partition of s and interpolate for a finer partition.

By Eq. 15, the premium leg is linear in the tranche spreads. Thus, equating the

premium leg and the default leg of a tranche, we can easily solve for the tranche spread.

2.3. Econometric Methodology

The default intensity factors (λ1t, λ2t, λ3t) in the LR model are not directly observable.

To calibrate our pricing model to the actual CDX tranche spreads, we adopt the MCEM

algorithm introduced in DEHS. This algorithm is a hybrid Maximum Likelihood method

which iteratively samples the latent factors and evaluates the likelihood by Monte Carlo

integration. As pointed out by Heitfield (2008) and CJS (2009b), a CDO structure is

sensitive to the parameter values, such as the expected default probability. Our method

explicitly accounts for the uncertainty in the default intensity (instantaneous default prob-

ability) factors and should be well-suited for our purpose.

To complete the pricing model, here we specify the market price of the diffusive risk of

each intensity factor. Dai and Singleton (2000) provides the completely affine specification

and Duffee (2002) provides the essentially affine specification of risk premium. In our case,

essentially affine risk premium coincide with the completely affine risk premium since our

intensity factors all follow CIR processes. However, both specifications only allow the

mean-reverting speed bi to be adjusted under the physical measure (P measure). To

make our model more flexible, here we adopt the extended affine specification provided

by Cheridito, Filipovic, and Kimmel (CFK 2005). This specification allows ai of Eq. 3,

Eq. 4, and Eq. 5 to be adjusted in addition to bi. Note that σi remains the same under

both the physical and risk-neutral measures. Define the market price of risk Λi as:

Λit =ηai + ηbiλit

σi√λit

, i=1, 2, 3. (17)

Then under the physical measure,

dλit = (aPi − bPi λit)dt+ σi√λitdWit, (18)

8

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where

ηai = aPi − aQi , ηbi = −bPi + bQi . (19)

Let Θ(Q) denotes the set of risk neutral parameters and Θ(P ) denotes the set of

objective parameters. We can write the tranche spreads as a function of the default

intensity factors, the principal remaining of the CDO underlying portfolio and the set of

risk neutral parameters. Let st be the vector of actual spreads of all tranches at time t

and we assume that the spreads are observed with pricing errors εt.

st = F (λt, Lt,Θ(Q)) + εt, (20)

where F is the pricing function and εt is multivariate Gaussian with mean 0 and variance-

covariance matrix Σ. Pricing errors for different tranches are assumed to be independent

of one another. Thus Σ is diagonal with Σii = σ2si. For simplicity, we further assume that

εt is not serially autocorrelated. Although the likelihood function will still be tractable if

we assume that εt follows some time series model, like AR(1), it can lead to much larger

pricing errors for the spreads.6

The specification of the pricing errors implies the following conditional density for the

joint observations, s = si,tk : i = 1, 2, ...,M ; k = 1, 2, ...N, with M CDO tranches and

N time periods.

p(s|λ, L,Θ(Q),Σ) =N∏k=1

p(stk |λtk , Ltk ,Θ(Q),Σ)

=N∏k=1

φ(stk ;F (λtk , Ltk ,Θ(Q)),Σ), (21)

where φ(x;µx,Σx) is a multi-variate normal density at x with mean µx and variance-

covariance matrix Σx.

Denote the joint likelihood of s and λ at the parameters Θ(P ), Θ(Q) and Σ as L. We

have

L(s, λ|Θ(P ),Θ(Q),Σ)

=N∏k=1

(p(stk |λtk , Ltk ,Θ(Q),Σ)

3∏i=1

p(λitk |λitk−1,Θ(P ))

), (22)

6Gaussian and i.i.d. pricing errors is also assumed by CFK when they fit their multi-factor model tobond yields. Eraker (2004) provides the density for AR(1) pricing errors.

9

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where p(λitk |λitk−1,Θ(P )) is the transition density of the CIR process and determined by

the physical dynamics. We make use of the Markov property of λitk for simplification.

The transition density of a CIR process is found in close form in Cox, Ingersoll, and

Ross (1985). Here, for simplicity, we use the Euler scheme to discretize the process to a

Gaussian approximation.7

p(λitk |λitk−1,Θ(P )) = φ(λitk − λitk−1

; (aPi − bPi λitk−1)∆tk−1, σ

2i λitk−1

∆tk). (23)

In a similar way as DEHS, the unobservable intensity factors can be sampled using

a combination of Gibbs sampler and Metropolis-Hasting sampler from the posterior dis-

tribution of λitk : i = 1, 2, 3; k = 1, 2, ...N.8 The Gibbs sampler iteratively draws λitk

(i = 1, 2, 3; k = 1, 2, ...N) from its condition distribution given λ(−itk), where (−itk) de-

notes the set of λ excluding λitk . The density function of this conditional distribution can

be written as

p(λitk |s, λ(−itk), L,Θ(P ),Θ(Q),Σ)

∝ p(λitk |λitk−1,Θ(P ))p(λitk+1

|λitk ,Θ(P ))p(st|λitk ,Θ(Q),Σ), (24)

where terms not involving λitk are constant hence dropped from the formula.9 Random

walk Metropolis-Hasting sampler can be applied to simulate λitk based on Eq. 24. One

advantage of Metropolis-Hasting algorithm is that we can directly reject the draws con-

strained by economic or technical reasons.10 In our case, the extended affine risk premium

specification will allow arbitrage opportunities when the boundary value of the CIR pro-

cesses is attained. To eliminate arbitrage, we reject any non-positive proposal of λitk .

For appropriate starting value of λ(0) and parameters Θ(P )(0), Θ(Q)(0) and Σ(0), we

can recursively draw λ(1), λ(2), ..., λ(n). The last several hundreds (m) of simulations for

λ are recorded and used to calculate the expected log-likelihood function ln(L). This is

7The discretization error can be reduced by simulating additional states between time interval of thedata observations as in Eraker (2001) and Jones (2003).

8See Geman and Geman (1984), Metropolis and Ulam (1949), and Hastings (1970). Johannes andPolson (2006) gives an overview of MCMC method in financial economics.

9The CDX underlying portfolio is revised due to changes in the credit quality of the names when a newseries is issued on the roll-over day. i.e. Firms downgraded to non-investment grade or becoming illiquidare replaced by some other firm(s) qualified. This roll-over causes discontinuity in the data when wechoose to work with the on-the-run series. To account for this problem, we discard p(λitk |λitk−1

,Θ(P ))for the roll-over day and p(λitk+1

|λitk ,Θ(P )) for the day before roll-over, respectively.10Gelfand, Smith, and Lee (1992) provides an alternative way to sample conditional on a specific region.

10

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the Expectation step (E-step).

ln(L) ≡ ln(L(Θ(P ),Θ(Q),Σ))

=1

m

m∑i=1

lnL(s, λ(i)|Θ(P ),Θ(Q),Σ). (25)

Then we can maximize the expected log-likelihood with respect to the parameters to

find Θ(P )(1), Θ(Q)(1) and Σ(1). This is the Maximization step (M-step). E-step and

M-step are iterated until reasonable convergence is achieved. The likelihood should be

non-decreasing in each step of the EM algorithm. The asymptotic standard errors of

the parameter estimates can be obtained from the Information matrix of the expected

complete data log-likelihood.

3. Fitting the Model to the CDX Index and Index Tranches

The rapid development of the credit derivative market allows investors to effectively trade

credit risk, either for hedging or taking exposure. The most popular credit derivatives

thus far have been perhaps the CDSs and CDOs. Standard CDS indices and index CDO

tranches started to trade in September 2003. Both the indices and index tranches have

attracted much market trading activity and created well established spread quotations.

The index CDO tranches are of particular interest to us since the tranche spreads are not

uniquely determined by the marginal behavior of each underlying firm, more importantly,

it reflects clustering of defaults which cannot be easily diversified away. In this paper,

we focus on CDO tranches associated with the Dow Jones CDX North America Invest-

ment Grade Index (CDX index, for short) which is the most liquid U.S. corporate credit

derivative index and closely investigated by previous studies.

3.1. The Data

Our data contain daily spreads on the CDX index and the associated 0-3, 3-7, 7-10, 10-15

and 15-30 CDO tranches for maturity 5 years. The CDX index consists of an equally

weighted basket of CDSs on 125 liquid investment grade firms. The index is based on

standard ISDA maturity date, in March and September. Detailed description of the index

can be found in LR and CJS. A series of the CDX index stays on-the-run for six months

until a new series which better represents the liquid investment grade bond universe is

issued every March and September. On average five to ten names in the basket are

replaced at the inception of a new series. As in LR, CJS and CDGY, we retain the

on-the-run series to form continuous time series for the spreads on the index and the

11

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tranches, since the market trading activity is most focused on the on-the-run series.

Our spread data cover time period September 2004 to September 2008 which corre-

sponds to CDX series 3 to 10. Series 3 through 8, which we define as the pre-crisis series,

are provided by CJS and downloaded from the American Economic Review website. Se-

ries 9 and 10 during the financial crisis are downloaded from Datastream and Bloomberg.

Both terminals collect spread quotations for the CDX index and index tranches from the

liquidity-contributing banks of the index. We use closing quotes on every Wednesday to

form the weekly time series of spreads (207 weeks). According to the market convention,

the 0-3 tranche is quoted by an upfront fee instead of a running spreads. A price of 30

for the 0-3 tranche at initiation of the contract means the investor is given 30% of the

notional value of the tranche as an upfront payment in addition to a running spread of

500 basis points. Other tranches are quoted by a fair premium at which neither the buyer

nor the seller needs to make an upfront payment. No defaults happened to the on-the-run

series for the period under our study.11

Summary statistics of the weekly CDX index and tranche spreads are provided in

Table 1. Panel A reports the mean, standard deviation, higher moments and serial corre-

lation of the spread series. The average spreads are decreasing from the junior mezzanine

3-7 tranche to senior 15-30 tranche. Kurtosis of the spreads are relatively large which

reflect the extremely high spreads observed in the financial crisis period. Panels B and C

report correlation of each series in levels and weekly changes, respectively. Correlation in

spread levels seems to be high. However, there is considerable independent variation in

the first difference of the spreads.

3.2. Empirical Results

LR fit the pricing model by minimizing the root mean square pricing errors. Our empirical

approach differs from LR in a number of aspects. Firstly, we use a maximum likelihood

criterion to estimate the parameters, together with a Bayesian approach to filtering the

default intensity state variables. Second, we do not restrict each of the intensity pro-

cesses to follow a martingale. Third, LR assume a different regime for each CDX series

and correspondingly fit the pricing model repeatedly for each CDX series. However, the

parameter estimates show considerable stability across CDX series as pointed out by LR.

The representativeness of the CDX index for the liquid investment grade bond universe

is maintained through the revision of the CDX underlying portfolio at roll-over, although

the revision presents some discontinuity in the data. We opt for a uniform regime and fit

11Defaults did happen when the series went off-the-run. i.e. Delphi was last include in series 3 anddefault in October 2005 when series 5 is on-the-run.

12

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one set of parameters for all CDX series. Last but not least, we extend the data series to

include the financial crisis of 2008.

The parameter estimates along with their asymptomatic standard errors and t-statistics

are reported in Table 2. Assuming a recovery rate of 50%, one single firm default leads to

a loss of 0.004 since each firm has a weight of 1/125=0.008 in the index. The estimated

jump size of the first Poisson process is 0.00375 which is consistent with the interpreta-

tion of an individual firm default. The jump size of the second Poisson process is 0.03729

which could represent a sectoral default as pointed out by LR. If we put the underlying

firms evenly in the 12 broad industry categories, an industry-default-event would bring

about a loss of 1/12*0.5=0.04167. The third Poisson process has a jump size as large as

0.37121 which corresponds to a catastrophic market-wide event in which about 74% of all

firms in the economy default.

The CDX index spread can be decomposed into the three components corresponding

to the three intensity factors, respectively. Contribution to the index by each component

is approximated by γiλi (i = 1, 2, 3) which represent the average expected default loss

incurred by each intensity factor. For the entire sample period, the idiosyncratic, sectoral

and market-wide intensity factors account for 65.8%, 12.2% and 22.0% of the total CDX

spread, respectively. A default loss of 0.38%, 3.7% and 37.1% of the portfolio are expected

to happen once every 0.9, 47.9 and 263 years.

The risk neutral dynamics of the intensity processes are all mean-reverting since bQ1 ,

bQ2 and bQ3 are estimated to be positive. However, the third intensity process is estimated

to be explosive under the physical measure as bP3 = bQ3 − ηb3 = −0.41816. The estimated

physical dynamics reflects the limitation of the relatively short time series of spread data

we engage in the empirical analysis. The 4 years’ data stopping at the high spreads

observe in the financial crisis have not reverted to the mean yet.

Volatilities of the first and second intensity processes are 0.31386 and 0.27432, respec-

tively. Both are larger than that of the third, 0.09358. The volatility estimates are jointly

determined by the risk neutral and physical dynamics in our model. Those estimates are

more comparable to one another when estimated under the risk neutral measure alone

as in LR. Our results suggest that the third intensity process are less volatile under the

physical measure.

Generally, the drift term is challenging to be tied down with high accuracy under the

physical measure unless we have a long time series of data. The lack of long time series

is reflected in our parameter estimates. None of ηb1, ηb2 and ηb3 is statistically significant.

However, such data problem is not particularly detrimental to our later study of market

integration. The risk neutral parameters are all estimated with high precision since the

13

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spreads are determined by the risk neutral model parameters. The t-statistics for the risk

neutral parameters are ubiquitously larger than 2.8. And the accuracy in the estimated

risk neutral dynamics is crucial for the construction of CDO portfolios below. The drift

terms of the intensity processes are of order dt, higher than the order of the innovations in

the Brownian motions,√dt. Therefore, the CDO portfolios representing the innovations

in the intensity processes are effective as long as the risk neutral parameters are tightly

estimated and the discrepancies are largely confined to the drift terms.

Pricing errors of the CDX tranches are usually within several basis points as reported

in Table II of LR. As we account for the uncertainty in the intensity processes, the pricing

errors become enlarged. The standard deviation of the pricing errors for the 0-3, 3-7,

7-10, 10-15 and 15-30 tranches are 3.6, 25.2, 18.6, 4.1 and 1.1 basis points, respectively.

The median along with the 1% and 99% percentiles of the sampled intensity processes

are shown in Fig. 1. Time series of the actual spreads and the median, 1% and 99%

percentiles of the model predicted spreads are graphed in Fig. 2. We use the pricing

model to convert the upfront payment of the 0-3 tranche to an equivalent running spread

and both are shown in Fig. 2. The posterior distribution of the intensity processes do

exhibit some extent of uncertainties. However, the fitted spreads follow closely with the

actual spreads, both before and during the crisis period. The CDX tranche spreads are

efficiently explained by the three-factor pricing model.

4. Integration of the CDX Tranches in the Financial Market

We now apply our model fit to the CDX tranche spreads, to study the market itself.

In particular, we ask whether these spreads have been reasonable, before and during the

crisis period, or whether the writers of these instruments have been able to set the spreads

in their own favor. Also, has this market been segmented away from the rest of the capital

market?

These questions have been intensively studied recently, with notable contributions

from CJS and CDGY. CJS make the point that since the senior CDO tranche represents

exposure to economic catastrophe, then it should command a high risk premium (high

spread), since insurance against economic catastrophe is particularly valuable, and the

Arrow-Debreu state price is high in this state of the world. They also note that out of the

money equity index puts represent the same exposure, and back out the Arrow-Debreu

state prices from the S&P 500 index (SPX) options. Then they develop a model to price

CDO tranches, in terms of these state prices, and conclude that the CDO spreads are too

14

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low12.

CDGY’s work continues the approach of CJS, but using a more complete modeling

framework13, in which the CDO spreads and the SPX option prices are integrated. In

particular, their model allows jumps in the equity index. The jumps are crucial to account

for the options smirk effect, which corresponds directly to the state price being high in

the event of economic catastrophe. CDGY conclude that their model fits well, and that

the CDO and SPX markets are integrated.

We will address the issue of CJS and CDGY via a less structural approach. Namely, we

ask whether the CDX tranches have offered excess returns, which could not be accounted

for in terms of standard risk factors in the market. The work of the previous section allows

us to represent the CDO market parsimoniously, in terms of the three default intensity

factors λ1, λ2, λ3, which we have extracted.

Our first task, done in the following section, is to form portfolios, which can be traded

for cash, and which represent exposure to each default intensity factor separately. We

then work with the weekly returns of these portfolios, net of financing costs. The Sharpe

ratio for such a net-return is its average divided by its standard deviation, and any

deviation of this ratio from zero represents an “excess” return. We will see that these

default intensity portfolios have Sharpe ratios which are not excessive, and in fact not

statistically significant for λ2 and λ3.

We then regress the net-returns of our default intensity portfolios against the net-

returns of portfolios representing standard factors in the market. In such regressions, a

significant regression coefficient indicates that the default intensity (regressand) factor can

be at least partially hedged with the regressor factors, and a significant intercept term

indicates that the regressors have not accounted for the risk factors in the regressand

factor.

Perhaps the most basic standard factor portfolios are the Fama-French portfolios rep-

resenting the market, firm size, and Book-to-Market (BTM) factors. However, more

interesting for our default intensity factors, in view of the work of CJS and CDGY are

the SPX option factors, representing the market factor (which is essentially the same as

12They suggest that the market has set these CDO tranche spreads too low, because it has ignored thefact that the Arrow-Debreu price will be high when these tranches default. They further suggest thatthis is because the market determines the CDO spread solely on the basis of the credit rating, and creditrating is assessed solely on the basis of the expectation of loss, also ignoring the state price in the eventof default.

13As pointed out by CDGY, in CJS’s model, defaults can only be recognized at maturity and defaultsare driven uniquely by diffusive uncertainty which usually cannot generate realistic spreads on its own(Eom, Helwege, and Huang (2004)). CDGY include a catastrophic jump and an idiosyncratic jump inthe firm dynamics. They further calibrate their default model to match the entire term structure of CDXindex spreads to exploit information regarding the timing of expected default.

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the corresponding Fama-French factor), the volatility factor, and the smirk factor. These

have been studied by CCD (2009), and we update the work of this paper, in Section B

below.

Our most important result below agrees with CDGY; the 3rd CDX tranche portfolio

price innovation is correlated with the smirk factor, and there is no excess return after

this hedge.

In Section D below, we will compare our approach with that of CJS and CDGY and

some more general approaches to the question of market integration. Briefly, our “less

structural” approach is in tune with studies of the integration of equity markets, and is

less dependent on the specification of the index options pricing model.

4.1. Constructing Tradable Portfolios for the LR Default Intensity Factors

Suppose we enter a CDO contract on tranche AB at its initiation date t0, with spread

sAB

(t0). Then ∀ t ≥ t0, the premium leg receives sAB

(t0)LAB(t)dt and the default leg

receives −dLAB(t) over a short time period dt starting at time t. The premium leg can be

hedged - just put the cash flow in a bank account. Therefore the default leg can effectively

be traded.

We can think of the default leg as an instrument that can be traded for the cash price

ZAB(t), and that pays a coupon −dLAB(s) ≥ 0, for t0 ≤ t ≤ s ≤ T (T is the maturity

time of the CDO.). In fact,

ZAB(t0) =∫ Tt0P st0

(−dLAB(s)) = sAB

(t0)∫ Tt0P st0LAB(s)ds, (26)

since the spread is fixed so that CDOPAB(t0) = CDOD

AB(t0) at the initiation of the contract.

According to Eq. 14, for t0 ≤ t ≤ T , we can calculate the price of the default leg as

ZAB(t) = ZAB(λt, Lt, t),

= −P Tt Et[LAB(T )] + LAB(t)− rt

∫ TtP st Et[LAB(s)]ds. (27)

The default leg is exposed to two kinds of risks: actual defaults, represented by dLt,

and the default intensity factor λt. The risk exposure of any CDODAB position to actual

defaults can be hedged using the default leg of the CDX (i.e. untranched) index. The

hedge ratio for tranche AB is ∆ABL such that

∂ZAB(λt, Lt, t)

∂Lt= −∆AB

L

∂ZX(λt, Lt, t)

∂Lt, (28)

where ZX(λt, Lt, t) is the price of the CDX index default leg. (Hedging the factor Lt is

16

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like hedging an equity option against its underlying, whereas hedging the factors λit is

like hedging against the volatility.) Also ZX(λt, Lt, t) is linear in Lt, so we can always

have the hedge ratio ∆ABL in Eq. 28 for Lt > 0. (Note that the hedge will not be perfect,

even if the time step is infinitesimal, because default represents a jump in Lt. Actually,

during our sample period, no default has actually happened to the on-the-run series, and

so this question does not arise in our empirical tests.)

Let us denote by ZAB(λt, t) the price of the CDO default leg, hedged against dLt. We

have

ZAB(λt, t) = ZAB(λt, Lt, t) + ∆ABL ZX(λt, Lt, t). (29)

This should be exposed solely to the intensity factors λt = (λ1t, λ2t, λ3t).

With at least three CDO tranches, ZAiBi(λt, t), i = 1, 2, ...M , we show how to form

portfolios which isolate each factor. Applying the Ito formula,

dZAiBi(λt, t) =

∂ZAiBi(λt, t)

∂tdt+

3∑k=1

∂ZAiBi(λt, t)

∂λktdλkt +

1

2

3∑k=1

∂2ZAiBi(λt, t)

∂λ2kt(dλkt)

2,

= rtZAiBi(λt, t)dt+

3∑k=1

σk√λkt

∂ZAiBi(λt, t)

∂λktdWkt, (30)

where dλkt is as defined in Eq. 3, Eq. 4, and Eq. 5. The above dynamics of ZAiBi(λt, t)

apply under the Q measure. The drift term on the RHS must be as stated since all assets

should earn a risk-free rate of return. Write in matrix form,

dZ(λt, t) = rtZ(λt, t)dt+ ΩtdWt, (31)

where Z(λt, t) = (ZA1B1(λt, t), ..., ZAMBM(λt, t))

T ; Ωt is an M × 3 matrix with (Ωt)ik =

σk√λkt

∂ZAiBi(λt,t)

∂λkt(i = 1, 2, ...M ; k = 1, 2, 3); dWt = (dW1t, dW2t, dW3t)

T . Note that under

the P measure, with risk premium Λkt corresponding to λkt, we have

dZ(λt, t) = (rtZ(λt, t) + ΩtΛt)dt+ ΩtdWt, (32)

where Λt = (Λ1t,Λ2t,Λ3t)T .

To isolate exposure dWt, to the default intensity factors (λ1t, λ2t, λ3t), as in Eq. 3, Eq. 4,

and Eq. 5, we merge some of the CDO tranches, so that we effectively have M = 3. The 7-

10, 10-15 and 15-30 tranches are exposed mostly to the third intensity factor since they are

deeply out of the money. Our calculation shows that the first derivatives of the hedged

tranche values with respect to the intensity factors are highly correlated across these

three tranches. Therefore, we merge the 7-10, 10-15 and 15-30 tranches into a bigger 7-30

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tranche. Together with the 0-3 and 3-7 tranches, we thus effectively have M = 3 tranches.

We can now invert the variance-covariance matrix Ωt to get the CDO portfolio price

innovations.14 Specifically, we can rewrite Eq. 31, as Ω(−1)t (dZ(λt, t)− rtZ(λt, t)) = dWt.

Our portfolios exposed purely to the factors (λ1t, λ2t, λ3t) are the linear combinations,

given by the matrix Ω−1t , of the Zt assets, corresponding to the 0-3, 3-7, 7-30 tranches.

Finally we subtract the financing cost from the CDO portfolios.

We obtain 207 weekly price innovations for each of the CDX tranche portfolios which

respectively represent the three intensity factors. We further discard the 7 roll-over weeks

in each innovation series since those observations capture the revision of the CDX index

as well. The cumulative price innovations are given in Fig. 3. These innovations tend to

be diffusive and present few large occasional jumps.

Summary statistics and diagnostic tests of the price innovations are reported in Ta-

ble 3. From Panel A, we see that all the Price innovations earn positive returns on average.

The skews in the price innovations are not extreme. To estimate the Sharpe ratio for each

factor, we regress the price innovations against the unit constant. Since the price innova-

tions are net of financing costs, the Sharpe ratio is the regression coefficient on the unit

constant, divided by the residual standard deviation. The Sharpe ratios for the three

price innovation series are 0.142, 0.066 and 0.090, respectively, comparable to the Sharpe

ratio earned by the equity market.15 The Sharpe ratio of the first price innovations is

statistically significant at 5% level.

Panel B reports the correlation among the price innovations. The three price inno-

vation series are positively correlated with one another, with correlation ranging from

0.39 to 0.52. The correlation is not extremely high. Independent variations of each price

innovation series are noticeable as in Fig. 3. Panel C shows that none of the three price

innovation series exhibits significant autocorrelation up to lag three weeks.

4.2. The CDX tranche factors versus the index options factors

With the price innovations representing the CDX tranche factors established as above,

now we examine how they are related to the general financial market, and in particular,

the S&P 500 index option market. We identify three factors in the S&P 500 index option

market: the first one is the underlying index excess return and the other two factors come

14Another way around is to choose three tranches which stand for the three intensity factors, respec-tively. i.e. the junior 0-3, the mezzanine 3-7 and senior 15-30 tranches react most sensitively to theidiosyncratic, sectoral and market-wide intensity factors, respectively. In unreported results, we confirmthat this method generates nearly identical tranche portfolio price innovations to those by the mergedtranches.

15Take the long term annual excess return of the equity market to be 8% and volatility to be 16%. TheSharpe ratio for the market is 0.5 annually and 0.5/

√52 = 0.069 weekly.

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from the first two principal components of the implied volatility dynamics of those index

options.

We obtain our option factors by performing a Principal Component Analysis (PCA) to

the implied volatility dynamics at a cross section of moneyness values. This method has

been implemented by CCD to S&P 500 index futures options. These authors also show

how the implied volatility dynamics can be related to the dynamics of the option prices

themselves: the option implied volatility innovation is of the same order as the Delta

hedged option price innovation, and normalized by the option Vega. Thus option port-

folios representing the dynamic factors to the principal components can be constructed

by replacing the implied volatility innovation by the hedged and normalized option price

innovation. Please refer to Appendix A for a brief description of the implementation. Re-

lating the implied volatility dynamic factors to innovations in actual prices enables CCD

to estimate risk premia for these factors. The options smirk can then be related to the

premium on the corresponding factor.

CCD shows that the first two principal components are essentially a parallel shift and

a cross-sectional tilting in the implied volatility innovations and these two components

account for an overwhelming part of the implied volatility dynamics. Therefore the two

dynamic factors of the first two principal components can be interpreted as corresponding

to the implied volatility and volatility smirk of the options, respectively. Together with

the underlying excess return, they extract three factors in the index futures option market.

Those option factors earn significant risk premia for a long time period from 1990 to 2000

and are useful for hedging option portfolios. Working with futures options delivers the

convenience that the futures price does not include the dividends paid by the underlying

index. However, the index options avoid the complexity of the American feature of the

futures options. To maintain comparable results with CJS and DGY who work with index

options, we conduct our analysis with the S&P 500 index options which are European.

We replicate the analysis of CCD using the S&P 500 index option data, obtained from

OptionMetrics, and covering the time period September 1998 to September 2008. This

period includes the period of our CDX data. We keep all Wednesdays to form weekly

series (519 weeks). Options are available for maturities up to three years. The risk free

term structure for each day is also provided by OptionMetrics and derived from BBA

LIBOR rates and settlement prices of CME Eurodollar futures. For each day, we choose

options with the shortest maturity beyond a roll-over period of 30 days. We further delete

all the option quotes which have no recorded trading for that day. The put-call parity for

European options with a continuous dividend yield is given as

Ste−y(T−t) + Pt = Ct +Xe−r(T−t), (33)

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where St is the index price at time t; y is the dividend yield; T is the maturity time.

Pt and Ct are the put and call option prices respectively; X is the strike price; r is the

risk-free interest rate.

The dividend yield can be easily implied from the prices of a put-call option pair

by Eq. 33. For each time t, we calculate the implied dividend yields for all the option

pairs with strike price in the range (0.95St, 1.05St) and choose the median as the implied

dividend yield for the whole set of options at time t.

We define the moneyness x of an option as x := XSte(r−y)(T−t) . We keep all the OTM

options. Thus x must be greater than 1 if the option is a call and smaller than 1 if

the option is a put. The implied volatility innovation for a given strike price X = x ×Ste

(r−y)(T−t) is calculated from the Black-Scholes formula. We linearly interpolate for the

implied volatility between the nearest strike prices if the option for a specific x does not

exist or is not traded.

We take moneyness points 0.90, 0.92, 0.94, 0.96, 0.98, 1.00, 1.02, 1.04 and 1.06, which

coincide with those in CCD. We assure that at least one distinct option is observed in be-

tween the given moneyness values during the whole sample period. The first two principal

components of the S&P 500 index option implied volatility dynamics at the moneyness

levels are shown in Fig. 4. We see that the first principal component is roughly a parallel

shift and the second principal component is a cross-sectional twist. The eigenvalues of the

first and second principal components make up 91.9% and 6.0% of the sum of all eigen-

values, respectively. 97.9% of the part of the implied volatility dynamics are captured by

the first 2 principal components.

As in CCD, we replace the implied volatility innovations by the price innovations,

net of financing costs, of a portfolio of options and the underlying index. Thus, we have

two dynamic factors of price innovations which respectively, corresponding to the first

and second principal components of the implied volatility dynamics, and these can be

realized by trading portfolios of options and the underlying index. Denote the factors as

∆Vol. and ∆Smirk, respectively. Together with the excess return on the S&P 500 index

(denoted as SPX Ret.), we have three tradable factors in the options market.

We obtain 519 weekly excess returns/price innovations for each of the three option

factors. The cumulative excess returns/price innovations of the three option factors are

given in Fig. 5. These returns/price innovations tend to accrue gradually and cannot

be dominated by several large jumps. Investing in the S&P 500 index is not profitable

during our sample period as a result of the Internet bubble and the recent financial crisis.

Consistent with Coval and Shumway (2001) and Bakshi and Kapadia (2003), the ∆Vol.

factor loses money. A delta hedged option portfolio can be regarded as an instrument to

20

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hedge against the market volatility and thus incurs a risk premium to be paid by the long

positions in such a portfolio. The ∆Smirk factor makes money on average, consistent

with the notion that OTM put options are more expensive than the OTM call options as

we are effectively shorting the OTM puts and longing the OTM calls.

Summary statistics and diagnostic tests on the option factors, for both the whole

sample period 1998-2008 and the subperiod 2004-2008 which coincides with our CDO

factors, are given in Table 4. The market index does not make significant excess returns

for both the entire sample period and the CDO period. The Sharpe ratios of the SPX

Ret. factor for both periods are not distinguishable from 0. However, the ∆Vol. factor

consistently earns significant negative returns for both periods. The Sharpe ratios for

both periods are -0.268 and -0.305, respectively, and significant at 1% level. The ∆Smirk

factor makes money only in the long run. The Sharpe ratio for the ∆Smirk factor is

0.097, significant at 5% level, for the whole sample period, but 0.017, not significant, for

the overlapping period.

Panel B shows that the three option factors are negatively correlated with one an-

other at about -20%. The negative correlations reflect that our construction of the price

innovations are not perfect as we rely on the Black-Scholes formula to derive option Delta

and Vega. The negative correlation between SPX Ret. and ∆Vol. factors could be cap-

turing the leverage effect.16 It is more pronounced during the overlapping period than

the entire sample period. Panel C presents the autocorrelation tests on the factors. The

significant negative coefficients observed here reflect mean-reversion in the market return

and ∆Smirk factor.

Regressions of the CDX tranche default intensity factors against the option factors are

reported in Table 5. We present regression or hedging results of each CDO intensity factor

with the three option factors, separately and altogether. Panel A reports the hedging

results for the first CDO intensity factor. Both the SPX Ret. factor and the ∆Vol. factor

are highly significantly correlated with the first CDO intensity factor. However, the

∆Smirk factor does not have significant effect on the first CDO intensity factor. When

we use the option factors together to hedge the first CDO intensity factor, the ∆Vol.

factor loses its significance. The adjusted R2 of the regressions confirms that the hedging

ability mainly comes from the SPX Ret. factor. SPX Ret. factor alone has an adjusted

R2 of 10.2%. When we add the ∆Vol. factor to the hedge, the adjusted R2 increases

slightly from 10.2% to 11.2% and remains essentially unaltered when we further include

the ∆Smirk factor. The constants of the five regressions range from 0.0051 to 0.0080,

which are comparable to or higher than the average of the first CDO intensity factor,

16See Black (1976) and Christie (1982).

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0.0052. The Sharpe ratios range from 0.143 to 0.218 and remains statistically significant

across all hedges.

Panel B reports the hedging results for the second intensity factor. Similarly, used

alone, both the SPX Ret. factor and the ∆Vol. factor are significantly correlated with the

second CDO intensity factor. But the ∆Smirk factor does not help to hedge the second

CDO intensity factor. When we use the option factors altogether to hedge the second

CDO intensity factor, the ∆Vol. factor loses its significance. SPX Ret. factor alone has

an adjusted R2 of 10.3%. When we add the ∆Vol. factor to the hedge, the adjusted R2

actually decreases slightly from 10.3% to 9.9% but increase largely from 9.9% to 14.1%

when we further hedge with the ∆Smirk factor. The constants of the five regressions

range from 0.0005 to 0.0016, while the average of the second CDO intensity factor is

0.0010. The Sharpe ratios vary between 0.031 and 0.104 across all hedges and none of

them is statistically significant.

Panel C reports the hedging results for the third intensity factor. Separately, the SPX

Ret. factor, the ∆Vol. factor and the ∆Smirk factor are all significantly correlated with

the third CDO intensity factor. When we use the option factors altogether to hedge the

third CDO intensity factor, the ∆Vol. factor loses its significance again. However, the

∆Smirk factor remains strongly statistically significant. SPX Ret. factor alone has an

adjusted R2 of 13.3%. When we add the ∆Vol. factor to the hedge, the adjusted R2

increases a little bit from 13.3% to 13.6%. When we further hedge with the ∆Smirk

factor, the adjusted R2 increase dramatically from 13.6% to 19.8%. The constants of the

five regressions range from 0.0014 to 0.0028, which are again equal to or higher than the

average of the third CDO intensity factor, 0.0015. The Sharpe ratios vary between 0.0089

and 0.163. The residual Sharpe ratio is significant when we hedge the third intensity

factor with the ∆Vol. factor alone and marginally significant when we hedge with the

SPX Ret. factor and ∆Vol. factor.

Each of the three CDO intensity factors stands for the probability of a certain type of

default events. They all rise when the market goes down, when the market becomes more

volatile and when a large downward jump of the market is more likely. Among the option

factors, the ∆Vol. factor rises as the market volatility increases. However, the ∆Smirk

factor falls when the volatility smirk becomes more extreme since our ∆Smirk factor is

in fact shorting the OTM puts which becomes more valuable under such circumstances.

Hence, we expect the CDO intensity factors to be positively correlated with the ∆Vol.

factor but negatively correlated with the SPX Ret. factor and the ∆Smirk factor. The

regression results presented in Table 5 are consistent with our prediction. All the simple

hedges with one of the option factors produce a correct sign. When we use multiply

22

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option factors to hedge the CDO intensity factors, the ∆Vol. factor loses its statistical

significance and sometimes even changes sign from positive to negative as in Panel B and

C. This could be due to the correlation of the ∆Vol. factor with the SPX Ret. factor and

the ∆Smirk factor.

The SPX Ret. factor seems to be the most helpful to hedge the CDO intensity factors.

It is highly significant no matter whether we use it alone or together with the other two

option factors for hedge. It also contributes to the largest portion of the regression R2,

compared with the other two option factors. With the presence of the SPX Ret. factor, the

contribution of the ∆Vol. factor to hedge the CDO intensity factors is marginal as judge

from its ability to increase the adjusted R2. The ∆Smirk factor tends to work differently

for the CDO intensity factors. The ∆Smirk factor can be interpreted as representing large

negative jumps in the market index. The first CDO intensity factor which corresponds

to a single firm default is not closely connected with the ∆Smirk factor. Panel A shows

that the ∆Smirk factor is not significantly related to the first CDO intensity factor and it

does not provide any extra hedging ability. However, the ∆Smirk factor should be tightly

related with the second and third CDO intensity factors as the market slumps when a

number of firms or a majority of the firms default together. Panel B shows that the

∆Smirk factor does increase the adjusted R2 although it is not significant in the simple

one-factor hedge. In Panel C, the ∆Smirk factor is significantly related with the third

CDO intensity factor and also exhibits considerable extra hedging ability.

In summary, the CDO intensity factors can be partially hedged by the option factors.

Particularly, the third CDO intensity factor is correlated with the ∆Smirk factor. Com-

mon variation between the CDO intensity factors and the option factors can be regarded

as evidence for market integration. CJS present similar results with respect to the CDX

index. They show that innovations in the CDX index spread can be predicted by using

information in the S&P 500 index option market. The residual Sharpe ratios are not

significant when the second and third CDO intensity factors are hedged with the SPX

Ret. factor and/or the ∆Smirk factor. We do not find evidence for market segmentation

in a sense that excess returns offered in one market cannot be accounted for by standard

factors in the other market. This result agrees with CDGY who conclude that S&P 500

options and CDX tranche market can be reconciled within an arbitrage-free framework.

But this result stands in contrast to CJS who claim that the senior CDX tranches are

asking too little compensation for the systematic risk they are bearing. Interestingly,

for all hedges, the first CDO intensity factor has significant Sharpe ratios. It seems not

spanned by the option market factors. The first CDO intensity factor represents a single

firm default event. Thus it has a risk profile similar to a first-to-default CDS. Instead

23

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of diversifying away the idiosyncrasies in the underlying portfolio of firms as the equally

weighted CDX index, the first CDO intensity factor should be sensitive to the underlying

firm with the worst credit quality. It is reasonable that the first CDO intensity factor

cannot be accounted for by the index option factors since a single firm only has marginal

effect on the broad well-diversified market index. We do not take the significant Sharpe

ratios of the first CDO intensity factor to be evidence of segmentation of the CDX tranche

market and the S&P 500 index option market.

4.3. The CDX tranches versus the Fama-French equity factors

Fama and French (1993) identify three stock market factors corresponding to the market

excess return, return to small firms minus return to large firms (SMB), and return to high

BTM firms minus return to low BTM firms (HML), respectively.

The results of hedging the CDO intensity factors with the FF factors are reported

in Table 6. We see that the market excess return is correlated with the three intensity

factors in all regressions. However, the HML factor is only correlated to the first intensity

factor and the SMB factor is marginally correlated with the third factor. All the Sharpe

ratios are not significant for the second and third intensity factors after we hedge with the

FF factors. The CDX tranche market is integrated with the stock market. Here again,

we do not take the significant Sharpe ratios from the first intensity factor as evidence for

market segmentation.

To further investigate whether the CDO intensity factors are helpful to explain stock

returns, we related those intensity factors to the standard size portfolios and BTM port-

folios formed by Fama and French (1993). Daily returns to these portfolios are provided

on French’s web data library. We accumulate over Thursday to next Wednesday to get

weekly returns. For each portfolio, we run a time series regression as follows:

rit − rf = αi + βim(rmt − rf ) + βiλj(rλjt − rf ) + εit, (34)

where rit is the portfolio return in time period t, rf is the risk-free rate, rmt is the market

return in time period t, and rλjt is the price innovation of the jth CDO intensity factor in

period t. Regression results for quintile size and BTM portfolios are reported in Table 7

and Table 8, respectively.

The first and second CDO intensity factor do not have significant betas to the size

portfolios. Betas of the third CDO intensity factor increase nearly monotonically from -

0.100 for the smallest size portfolio to 0.000 for the largest size portfolio. And the smallest

size portfolio loads significantly on the third CDO intensity factor. Small firms appear

24

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to experience worse returns when a catastrophic default event is more likely. However,

large firm tend not to be sensitive to such economic catastrophe. All the intensity factors

should lose money on average as investors pay a premium to hedge the risk. Thus small

firms earn expected returns higher than those justified by the CAPM.

For the BTM portfolios, the second CDO intensity factor still does not have significant

betas. Betas of the first and third CDO intensity factor decrease monotonically for the

lowest BTM portfolio to the highest BTM portfolio. The lowest BTM portfolio loads

positively and significantly on the first CDO intensity factor. And the highest BTM

portfolio loads negatively and significantly on both the first and third CDO intensity

factor. High BTM firms appear to experience worse returns when the first or third CDO

intensity factor rises. However, low BTM firm tend to be sensitive only to the first CDO

intensity factor. Since all the intensity factors lose money on average, high BTM firms

earn expected returns higher than low BTM firms.

4.4. Discussion

In the previous section we have seen that the CDX senior tranche spreads are related to

the index options smirk (which corresponds to the price of insuring against a large market

decline). This result agrees with the insight of CJS. But we have not found evidence of

the CDO trance spreads mispricing this risk, agreeing with CDGY. We have also seen

that the CDX junior tranche is related to the book to market factor of Fama and French.

In this section we put our approach into a broader context, and compare it with the

approach of CJS and CDGY.

Our approach is to construct portfolios from the CDX tranches, which can be traded

for cash, and to look at the returns of these. We regress these returns against returns

of portfolios representing standard factors. A significant regression coefficient reveals

common variations between the markets, so that we can hedge one market against the

other. A residual intercept tells us whether there are excess returns left to be explained

after the hedge. This approach falls into the framework of Fama and French (1993; 1996),

who show that their factors of market, size, and book-to-market capture a dominating

part of the common variations in the equity market. In working with option prices, we

have identified the factors using PCA. PCA is commonly used in studying equity markets,

for example by Roll and Ross (1980) and recently by Pukthuanthong and Roll (2009).

The approach of CJS and CDGY is more structural than ours, and relies on designing

an integrated, completely specified model for both the CDX tranche spreads and the

index option prices. Their tests are joint tests of whether the markets are integrated, and

whether the model is well specified for both markets together. By contrast, our approach

25

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is able to deal with each market separately, to extract tradable portfolios, and then it uses

simple hedging regressions to test whether the markets are integrated. Our approach is

more flexible, and enables us to test the CDX tranche spreads against the Fama-French

equity market factors, as well as the index option factors.

In Table 9 we take all factors we have identified together to hedge the CDO intensity

factors, and also a new factor CreditSpread, which is constructed as the price innovations

of the default leg of the CDX index. CreditSpread is a risk factor which belongs to the

CDX market, and could be extracted by combining the tranched components. We can see

that the CDO intensity factors can be partially hedged by the option and equity market

factors, but the R2 never rises above 20%. A large part of the variable risk in the CDX

tranche market cannot be explained by standard factors in the equity and equity derivative

markets. However, when we put in the CreditSpread factor, the R2 rises to 64%. The low

R2 in our hedges using market factors are thus largely caused by this CreditSpread factor.

A factor similar to this one has been identified in Collin-Dufresne, Goldstein, and Martin

(2001), which studies dealer’s quotes and transactions prices on straight industrial bonds.

They note that monthly changes in bond spreads can be explained by standard factors of

credit risk and liquidity to a R2 of 25%. However, a factor measured as Datastream’s BBB

Index Yield minus 10-year Treasury yield increases the R2 to over 60%. They conclude

that a large part of changes in bond spreads represents the supply-demand effect peculiar

to the bond market.

4.5. Robustness check

We work with S&P 500 index options with the shortest maturity beyond roll-over to

extract our option factors. The maturities of the options tend to vary from week to week.

CCD agree with the conclusion of Skiadopoulos, Hodges, and Clewlow (2000) that the

implied volatility structure is not sensitive to time-to-maturity. Here we provide a related

robustness check of our integration results by standardizing the option moneyness with

time-to-maturity. We define moneyness as

x :=ln(X/F )

σATM

√T − t

, (35)

where F = Ste(r−y)(T−t) is the futures price and σ

ATMis the ATM implied volatility.

We take moneyness points -1.5, -1.2, -0.9, -0.6, -0.3, 0.0, 0.3, 0.6 and 0.9. The PCA

and the corresponding dynamic factors, not presented here, highly resemble the results

we get in section B. The first principal component is largely a parallel shift and explain

90.3% of the implied volatility dynamics. The second principal component is a cross-

26

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sectional twist and account for 6.8% of the implied volatility dynamics. The ∆Vol. and

∆smirk factors (as define before) earn negative returns and positive returns on average,

respectively. The results for hedging the CDO intensity factors with the option factors

are reported in Table 10. We see that the results are essentially unchanged. Although

the regression R2 drop a little bit as compared to Table 5, the second and third intensity

factor can be spanned by the option factors and the smirk factor is significantly correlated

with the third intensity factor.

5. Conclusion

In this paper we first design a procedure to value CDO tranches in an intensity-based

model. Then we implement the model to the CDO tranches, associated with the cash

flow of the well-established CDX index. The CDX tranche spreads can be effectively

explained by the CDO pricing model with three default intensity factors. We extract

three intensity factors which stand for default of one firm, several firms together and a

majority of the firms in the economy, respectively. Then we form CDX tranche portfolios,

which can be effectively traded, and represent those intensity factors.

We further test the integration of the CDX tranches in the general financial market.

We extract three option factors by performing PCA to the implied volatility dynamics

of the S&P 500 index options. The option factors correspond to the underlying index

return, the implied volatility and the volatility smirk, respectively, and account for an

overwhelming part of the implied volatility dynamics. The volatility and smirk factor both

earn a significant risk premium in the long run. The option factors can also be realized

by trading option portfolios. Time series regressions show that the CDO intensity factors

can be partially hedged by the option factors. In particular, the third CDO intensity

factor, which represents market-wide default event, is correlated with the option Smirk

factor. The residual Sharpe ratios for the second and third CDO intensity factors are not

significant when we hedge the intensity factors with the option factors all together. In

sum, our results agree with CDGY, though our approach is less structural, in concluding

that the CDX index tranche market and the S&P 500 index option market are integrated.

Finally, we test our default intensity factors against the Fama-French factors for the

equity market. We do not find significant Sharpe ratios for the second and third intensity

factors after we hedge them against the FF factors. The CDX tranche market is thus inte-

grated with these stock market factors. Small firms and high BTM firms load negatively

and significantly on the third CDO intensity factor. Low BTM firms load positively and

significantly on the first CDO intensity factor.

27

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Appendix A. Construction of the option portfolios

Define the option implied volatility σx,Tt to be such that Φx,Tt = BS(St, x, rt, σ

x,Tt , T − t),

where Φx,Tt is the option price at time t; St is the underlying price at time t; x is the

moneyness; rt is the risk free rate; T is the maturity time and BS is the Black-Scholes

option valuation formula. Assume the underlying price, option price and hence the implied

volatility are Ito processes. Then we have

δΦx,Tt = ∆x,T

t (St, σx,Tt )δSt + V x,T

t (St, σx,Tt )δσx,Tt +O(δt),

in which ∆ and V are the Black-Scholes option Delta and Vega, respectively. δΦx,Tt , δSt

and δσx,Tt are of order O(√δt). Other derivatives and Ito correction terms are subsumed

in O(δt). It is easy to get

δσx,Tt = [(δΦx,Tt − rtΦx,T

t δt)−∆x,Tt δSt]/V

x,Tt +O(δt).

Thus the innovation in the implied volatility is of the same order as the price innovation

of the Delta hedged option portfolio, net of financing cost and normalized by Vega. More

details of the PCA and the construction of option portfolios can be found in CCD.

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Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 Mar08 Sep080.5

1

1.5

2First Intensity Process

Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 Mar08 Sep080

0.05

0.1

0.15Second Intensity Process

Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 Mar08 Sep080

0.01

0.02

0.03Third Intensity Process

Fig. 1. Intensity factor processes. For each of the three factors, the solid (red) line is themedian of the simulated intensity processes, with the lower and upper dashed (blue) lines as the1% and 99% quantiles, respectively.

33

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Sep04 Sep05 Sep06 Sep07 Sep080

1000

2000

3000

40000−3% Tranche

Spr

ead(

bps)

Sep04 Sep05 Sep06 Sep07 Sep080

250

500

750

10003−7% Tranche

Spr

ead(

bps)

Sep04 Sep05 Sep06 Sep07 Sep080

100

200

300

400

5007−10% Tranche

Spr

ead(

bps)

Sep04 Sep05 Sep06 Sep07 Sep080

100

200

30010−15% Tranche

Spr

ead(

bps)

Sep04 Sep05 Sep06 Sep07 Sep080

0.2

0.4

0.6

0.80−3% Tranche

Upf

ront

Fee

Sep04 Sep05 Sep06 Sep07 Sep080

50

100

15015−30% Tranche

Spr

ead(

bps)

Actual Fitted

Fig. 2. Time series of actual and fitted CDX tranche spreads. The solid (red) lines arethe historical CDX tranche spreads traded in the market. The three dashed (black) lines arerespectively the 1%, 50% and 99% quantiles of the model fitted spreads, for the 0-3%, 3-7%,7-10%, 10-15% and 15-30% tranches. The first subgraph gives the real and fitted upfront fee forthe 0-3% tranche.

34

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Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 Mar08 Sep08−0.2

0

0.2

0.4

0.6

0.8

1

1.2

Cum

ulat

ive

pric

e in

nova

tions

λ1

λ2

λ3

Fig. 3. Cumulative price innovations of the CDO factors. This figure shows the cumulativeprice innovations of the CDX tranche portfolios representing the three CDO intensity factors,respectively.

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0.88 0.9 0.92 0.94 0.96 0.98 1 1.02 1.04 1.06 1.08−0.01

−0.005

0

0.005

0.01

0.015

0.02

1st PC2nd PC

Fig. 4. First and second principal components of the implied volatility innovations. The x-axisdenotes moneyness, i.e. the strike price divided by the underlying futures price. The first andsecond principal components account for 91.7% and 6.2% of the implied volatility dynamics,respectively.

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1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008−5

−4

−3

−2

−1

0

1

2

3

Cum

ulat

ive

retu

rns

and

pric

e in

nova

tions

SPX Ret.

∆Vol.

∆Smirk

Fig. 5. Cumulative returns of the three option factors. This figure shows the cumulative excessreturns to the underlying S&P 500 index and cumulative price innovations to the volatility andsmirk option price factors.

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Table 1Summary statistics for the CDX index and index tranche spreads.

This table reports summary statistics for the weekly spreads of the CDX North American InvestmentGrade Index and Index Tranches. The sample period is September 2004 to September 2008 (208 weeks).We include the on-the run CDX series 3 to 10. Upfront fee (in percentage) is given for 0-3% tranche.

Index 0-3 3-7 7-10 10-15 15-30

Panel A. Summary statistics of weekly seriesMean 61.32 38.40 212.35 85.74 43.95 22.06S.D. 33.32 11.32 165.40 100.28 55.70 28.41Min. 29.25 18.25 59.50 11.50 4.50 2.25Med. 48.25 36.38 141.45 41.34 21.83 9.00Max. 180.39 68.20 790.14 421.62 254.78 123.30Skewness 1.63 0.45 1.56 1.72 1.90 1.84Kurtosis 4.63 2.31 4.47 4.71 5.53 5.2Serial corr. 0.979 0.963 0.976 0.984 0.977 0.978

Panel B. Correlations between weekly seriesIndex 1.0000-3 0.885 1.0003-7 0.973 0.845 1.0007-10 0.977 0.809 0.988 1.00010-15 0.979 0.806 0.973 0.989 1.00015-30 0.987 0.827 0.960 0.978 0.987 1.000

Panel C. Correlations between changes in weekly seriesIndex 1.0000-3 0.596 1.0003-7 0.721 0.751 1.0007-10 0.742 0.634 0.908 1.00010-15 0.697 0.457 0.732 0.828 1.00015-30 0.817 0.543 0.716 0.839 0.850 1.000

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Table 2Parameter Estimates

This table reports the parameter estimates of the three-factor pricing model. Asymptotic standarderrors are calculated using the Hessian matrix of the expected complete data likelihood function at theparameter estimates.

Parameter Coefficient Std. Error t-statistic

aQ1 0.05903 0.00117 50.59

aQ2 0.00112 0.00025 4.42

aQ3 0.00016 0.00001 14.49

bQ1 0.09209 0.00429 21.46

bQ2 0.02930 0.01040 2.82

bQ3 0.07429 0.00903 8.23σ1 0.31386 0.00905 34.66σ2 0.27432 0.01322 20.75σ3 0.09358 0.00525 17.81γ1 0.00375 0.00003 128.95γ2 0.03729 0.00094 39.87γ3 0.37121 0.01193 31.13ηa1 1.44791 0.80026 1.81ηa2 0.01919 0.00577 3.33ηa3 0.00238 0.00117 2.04ηb1 -1.14195 0.76070 -1.50ηb2 -0.37444 1.05446 -0.36ηb3 0.49245 0.87238 0.56σs1 3.59204 0.17682 20.31σs2 25.20429 1.32276 19.05σs3 18.62298 1.04858 17.76σs4 4.10957 0.22775 18.04σs5 1.08160 0.05353 20.21

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Table 3Summary statistics and diagnostic test of CDO portfolio factors.

Panel A reports the summary statistics of the price innovations of the CDX tranche portfolios repre-senting the three CDO factors, denoted as λ1, λ2 and λ3, respectively. Panel B presents the correlationsbetween the CDO portfolio factors and Panel C shows the autocorrelations of the factors. t-1, t-2 andt-3 denote the lag 1, 2 and 3-week CDO portfolio factors, respectively. The sample period is September2004 to September 2008 (200 weeks).

λ1 λ2 λ3

Panel A. Summary statistics of the factorsMean 0.0052 0.0010 0.0015S.D. 0.0365 0.0152 0.0169Min. -0.0653 -0.0505 -0.0381Med. -0.0020 0.0009 -0.0002Max. 0.2326 0.0609 0.0959Skewness 2.1021 0.6281 1.6329Sharpe Ratio 0.1418 0.0657 0.0903

(1.99) (0.92) (1.27)No. of Obs. 200 200 200

Panel B. Correlations between the factorsλ1 1.0000λ2 0.3825 1.0000λ3 0.5199 0.3880 1.0000

Panel C. Autocorrelation tests on the factorsConstant 0.0051 0.0009 0.0012

(1.89) (0.82) (0.97)t-1 0.0258 0.0701 0.0968

(0.36) (0.97) (1.34)t-2 0.0150 -0.0085 0.0835

(0.21) (-0.12) (1.15)t-3 -0.0221 0.0463 0.0346

(-0.30) (0.64) (0.48)Adj. R-squared -0.014 -0.009 0.005

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Table 4Summary statistics and diagnostic tests on the option portfolio factors

Panel A reports the summary statistics of the three option portfolio factors. SPX Ret. is theunderlying S&P 500 index excess return. ∆Vol. and ∆Smirk are the price innovations of the S&P 500index option portfolios corresponding to the parallel movement and cross-sectional tilting of the impliedvolatilities, respectively. Panel B presents the correlations between the option factors and Panel C showsthe autocorrelations of the factors. t-1, t-2 and t-3 denote the lag 1, 2 and 3-week option factors,respectively. The full sample is from September 1998 to September 2008 (519 weeks). We also report thesame results for the sample period of our CDX market quotations. The overlapping period is September2004 to September 2008 (207 weeks).

Full sample (1998-2008) Overlapping period(2004-2008)

SPX Ret. ∆Vol. ∆Smirk SPX Ret. ∆Vol. ∆Smirk

Panel A. Summary statistics of the factorsMean -0.0001 -0.0087 0.0036 -0.0002 -0.0075 0.0005S.D. 0.0229 0.0325 0.0369 0.0162 0.0246 0.0271Min. -0.0764 -0.1026 -0.1241 -0.0617 -0.0541 -0.1086Med. 0.0002 -0.0127 0.0024 0.0007 -0.0102 0.0024Max. 0.1068 0.1902 0.2098 0.0398 0.1450 0.0674Skewness 0.2582 2.1623 0.3421 -0.5556 2.3540 -0.6906Sharpe Ratio -0.0033 -0.2676 0.0967 -0.0092 -0.3050 0.0166

(-0.07) (-6.09) (2.20) (-0.13) (-4.38) (0.24)No. of Obs. 519 519 519 207 207 207

Panel B. Correlations between the factorsSPX Ret. 1.0000 1.0000∆Vol. -0.1958 1.0000 -0.4613 1.0000∆Smirk -0.2340 -0.2093 1.0000 -0.2436 -0.2557 1.0000

Panel C. Autocorrelation tests on the factorsConstant -0.0001 -0.0083 0.0042 -0.0002 -0.0063 0.0000

(-0.1) (-5.22) (2.61) (-0.14) (-3.31) (0.00)t-1 -0.1034 0.0127 -0.1998 -0.1156 -0.1239 -0.1546

(-2.35) (0.29) (-4.52) (-1.62) (-1.78) (-2.21)t-2 0.0217 -0.0337 -0.0259 0.0798 0.1438 0.0430

(0.49) (-0.77) (-0.57) (1.12) (2.09) (0.61)t-3 0.0373 0.0792 0.0151 -0.0239 0.1738 -0.0434

(0.85) (1.8) (0.34) (-0.34) (2.52) (-0.62)Adj. R-squared 0.007 0.002 0.033 0.009 0.045 0.017

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Table 5Hedging the CDO tranches with the S&P 500 index options

This table reports the hedging results of the CDO intensity factors with the S&P 500 index optionfactors. The sample period is September 2004 to September 2008 (200 weeks). The CDO intensity factorsare constructed as the price innovations of the CDO portfolios which represent those three factors. SPXRet. is the underlying S&P 500 index excess return. ∆Vol. and ∆Smirk are the price innovations of theS&P 500 index option portfolios corresponding to the parallel movement and cross-sectional tilting ofthe implied volatilities, respectively. Sharpe Ratio is calculated as the regression coefficient on the unitconstant divided by the residual standard deviation.

(1) (2) (3) (4) (5)

Panel A. Hedging results for the first CDO intensity factorSPX Ret. -0.7387 -0.5902 -0.6625

(-4.86) (-3.44) (-3.54)∆Vol. 0.3859 0.2042 0.1552

(3.82) (1.83) (1.26)∆Smirk -0.0449 -0.0973

(-0.47) (-0.96)Constant 0.0051 0.0080 0.0052 0.0066 0.0063

(2.10) (3.07) (2.01) (2.59) (2.44)

Sharpe Ratio 0.149 0.218 0.143 0.185 0.174Adj. R-squared 0.102 0.064 -0.004 0.112 0.112

Panel B. Hedging results for the second CDO intensity factorSPX Ret. -0.3101 -0.3184 -0.4187

(-4.90) (-4.42) (-5.45)∆Vol. 0.0867 -0.0114 -0.0793

(2.01) (-0.24) (-1.58)∆Smirk -0.0614 -0.1349

(-1.55) (-3.26)Constant 0.0010 0.0016 0.0010 0.0009 0.0005

(0.97) (1.47) (0.96) (0.84) (0.44)

Sharpe Ratio 0.069 0.104 0.068 0.060 0.031Adj. R-squared 0.103 0.015 0.007 0.099 0.141

Panel C. Hedging results for the third CDO intensity factorSPX Ret. -0.3873 -0.3386 -0.4717

(-5.61) (-4.33) (-5.74)∆Vol. 0.1713 0.0670 -0.0232

(3.66) (1.32) (-0.43)∆Smirk -0.1113 -0.1790

(-2.57) (-4.04)Constant 0.0015 0.0028 0.0016 0.0020 0.0014

(1.36) (2.30) (1.34) (1.71) (1.24)

Sharpe Ratio 0.097 0.163 0.095 0.122 0.089Adj. R-squared 0.133 0.059 0.027 0.136 0.198

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Table 6Hedging the CDO tranches with the Fama-French factors

This table reports the hedging results of the CDO intensity factors with the Fama-French threefactors. The sample period is September 2004 to September 2008 (200 weeks). The CDO intensityfactors are constructed as the price innovations of the CDO portfolios which represent those three factors.Mkt-Rf is the market excess return. SMB are the return difference between small and large firms. HMLare the return difference between high and low BTM firms. Sharpe Ratio is calculated as the regressioncoefficient on the unit constant divided by the residual standard deviation.

(1) (2) (3) (4)

Panel A. Hedging results for the first CDO intensity factorMkt-Rf -0.7187 -0.7434

(-4.94) (-4.86)SMB -0.3545 0.1094

(-1.34) (0.42)HML -0.6482 -0.6609

(-2.51) (-2.70)Constant 0.0055 0.0053 0.0059 0.0062

(2.24) (2.05) (2.30) (2.55)

Sharpe Ratio 0.159 0.146 0.163 0.182Adj. R-squared 0.105 0.004 0.026 0.129

Panel B. Hedging results for the second CDO intensity factorMkt-Rf -0.2913 -0.3313

(-4.79) (-5.14)SMB -0.0043 0.1965

(-0.04) (1.77)HML -0.1084 -0.1189

(-0.99) (-1.15)Constant 0.0011 0.0010 0.0011 0.0012

(1.10) (0.93) (1.03) (1.18)

Sharpe Ratio 0.078 0.066 0.073 0.084Adj. R-squared 0.099 -0.005 0.000 0.110

Panel C. Hedging results for the third CDO intensity factorMkt-Rf -0.3771 -0.3788

(-5.72) (-5.40)SMB -0.2267 0.0044

(-1.87) (0.04)HML -0.1794 -0.1842

(-1.49) (-1.64)Constant 0.0017 0.0016 0.0017 0.0019

(1.52) (1.35) (1.44) (1.69)

Sharpe Ratio 0.108 0.096 0.102 0.121Adj. R-squared 0.137 0.012 0.007 0.140

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Table 7Time series regressions of the size portfolios against the CDO factors

This table reports the time series regression of the size quintile portfolio returns against the marketand CDO intensity factor portfolio price innovations. λ1, λ2 and λ3 denote the first, second and thirdintensity factors, respectively. Mkt-Rf is the market excess return. Each regression is estimated withweekly data from September 2004 to September 2008 (200 weeks).

Lo 20 Qnt 2 Qnt 3 Qnt 4 Hi 20

Panel A. the first intensity factorMkt-Rf 1.095 1.243 1.112 1.057 0.963

(21.80) (24.84) (29.92) (37.55) (214.45)λ1 -0.041 -0.005 -0.005 -0.018 0.002

(-1.85) (-0.21) (-0.31) (-1.44) (1.11)Intercept 0.000 0.001 0.001 0.001 0.000

(0.22) (1.34) (1.90) (1.76) (0.17)Adj. R-squared 0.739 0.777 0.835 0.890 0.996

Panel B. the second intensity factorMkt-Rf 1.131 1.266 1.127 1.072 0.963

(22.33) (25.36) (30.35) (37.85) (214.40)λ2 0.021 0.063 0.036 0.006 0.006

(0.39) (1.19) (0.91) (0.18) (1.19)Intercept -0.000 0.001 0.001 0.001 0.000

(-0.08) (1.24) (1.81) (1.54) (0.26)Adj. R-squared 0.735 0.778 0.836 0.889 0.996

Panel C. the third intensity factorMkt-Rf 1.086 1.241 1.109 1.063 0.962

(21.30) (24.37) (29.32) (36.96) (209.70)λ3 -0.100 -0.013 -0.019 -0.018 -0.000

(-2.05) (-0.27) (-0.52) (-0.64) (-0.03)Intercept 0.000 0.001 0.001 0.001 0.000

(0.14) (1.34) (1.92) (1.62) (0.34)Adj. R-squared 0.740 0.777 0.835 0.890 0.996

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Table 8Time series regressions of the BTM portfolios against the CDO factors

This table reports the time series regression of the BTM quintile portfolio returns against the marketand CDO intensity factor portfolio price innovations. λ1, λ2 and λ3 denote the first, second and thirdintensity factors, respectively. Mkt-Rf is the market excess return. Each regression is estimated withweekly data from September 2004 to September 2008 (200 weeks).

Lo 20 Qnt 2 Qnt 3 Qnt 4 Hi 20

Panel A. the first intensity factorMkt-Rf 0.971 0.945 0.975 0.974 1.148

(30.94) (35.22) (41.29) (37.44) (31.85)λ1 0.033 0.008 -0.003 -0.007 -0.038

(2.39) (0.70) (-0.27) (-0.64) (-2.38)Intercept -0.000 0.000 0.001 0.001 0.000

(-0.97) (0.62) (1.73) (1.71) (0.70)Adj. R-squared 0.837 0.873 0.906 0.888 0.857

Panel B. the second intensity factorMkt-Rf 0.957 0.955 0.981 0.989 1.172

(30.12) (35.83) (41.52) (38.02) (32.05)λ2 0.035 0.053 0.012 0.028 -0.011

(1.04) (1.86) (0.48) (1.03) (-0.29)Intercept -0.000 0.000 0.001 0.001 0.000

(-0.69) (0.61) (1.67) (1.56) (0.37)Adj. R-squared 0.833 0.875 0.906 0.889 0.853

Panel C. the third intensity factorMkt-Rf 0.963 0.956 0.980 0.982 1.124

(29.86) (35.23) (40.77) (37.04) (31.37)λ3 0.043 0.044 0.007 0.005 -0.135

(1.38) (1.71) (0.30) (0.20) (-3.95)Intercept -0.000 0.000 0.001 0.001 0.000

(-0.75) (0.57) (1.67) (1.61) (0.74)Adj. R-squared 0.834 0.875 0.906 0.888 0.864

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Table 9Hedging the CDO tranches with factors from general financial market

This table reports the hedging results of the CDO intensity factors with factors from the bond,equity and option market. The sample period is September 2004 to September 2008 (200 weeks). TheCDO intensity factors are constructed as the price innovations of the CDO portfolios which representthose three factors. SPX Ret. is the underlying S&P 500 index excess return. ∆Vol. and ∆Smirk arethe price innovations of the S&P 500 index option portfolios corresponding to the parallel movementand cross-sectional tilting of the implied volatilities, respectively. SMB are the return difference betweensmall and large firms. HML are the return difference between high and low BTM firms. Mkr-Rf isomitted from the regression since it is highly correlated with SPX Ret.. CreditSpread is calculated as theprice innovations of the 5-year CDX index. Sharpe Ratio is calculated as the regression coefficient on theunit constant divided by the residual standard deviation.

λ1 λ1 λ2 λ2 λ3 λ3

SPX Ret. -0.6652 0.1166 -0.4370 -0.1496 -0.4601 -0.0913(-3.52) (0.79) (-5.58) (-2.22) (-5.5) (-1.48)

∆Vol. 0.1456 0.2072 -0.0788 -0.0561 -0.0269 0.0022(1.2) (2.36) (-1.56) (-1.41) (-0.5) (0.06)

∆Smirk -0.0839 0.1258 -0.1284 -0.0513 -0.1788 -0.0798(-0.84) (1.69) (-3.08) (-1.52) (-4.02) (-2.59)

SMB -0.0160 -0.1187 0.1228 0.0850 -0.0899 -0.1384(-0.06) (-0.64) (1.15) (1.01) (-0.79) (-1.79)

HML -0.6235 -0.3032 -0.1021 0.0156 -0.1502 0.0009(-2.55) (-1.70) (-1.01) (0.19) (-1.38) (0.01)

CreditSpread 12.1305 4.4587 5.7232(13.36) (10.82) (15.2)

Constant 0.0069 0.0050 0.0005 -0.0002 0.0016 0.0007(2.70) (2.68) (0.50) (-0.22) (1.39) (0.86)

Sharpe Ratio 0.195 0.194 0.036 -0.016 0.101 0.062Adj. R-squared 0.132 0.547 0.142 0.463 0.201 0.634

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Table 10Robustness check for standardized option moneyness

This table reports the hedging results of the CDO intensity factors with the S&P 500 index optionfactors, which come from the PCA with standardized option moneyness definition. The sample period isSeptember 2004 to September 2008 (200 weeks). The CDO intensity factors are constructed as the priceinnovations of the CDO portfolios which represent those three factors. Again, SPX Ret. is the underlyingS&P 500 index excess return. ∆Vol. and ∆Smirk are the price innovations of the S&P 500 index optionportfolios corresponding to the parallel movement and cross-sectional tilting of the implied volatilities,respectively. Sharpe Ratio is calculated as the regression coefficient on the unit constant divided by theresidual standard deviation.

(1) (2) (3) (4) (5)

Panel A. Hedging results for the first CDO intensity factorSPX Ret. -0.7387 -0.5909 -0.6380

(-4.86) (-3.44) (-3.41)∆Vol. 0.3810 0.1998 0.1649

(3.81) (1.81) (1.34)∆Smirk -0.0431 -0.0766

(-0.39) (-0.65)Constant 0.0051 0.0079 0.0052 0.0066 0.0063

(2.10) (3.05) (2.00) (2.57) (2.44)

Sharpe Ratio 0.149 0.217 0.142 0.183 0.174Adj. R-squared 0.102 0.064 -0.004 0.112 0.109

Panel B. Hedging results for the second CDO intensity factorSPX Ret. -0.3101 -0.3144 -0.4086

(-4.90) (-4.35) (-5.33)∆Vol. 0.0906 -0.0058 -0.0757

(2.12) (-0.12) (-1.50)∆Smirk -0.0760 -0.1532

(-1.65) (-3.15)Constant 0.001 0.0017 0.0010 0.0009 0.0004

(0.97) (1.49) (0.93) (0.88) (0.41)

Sharpe Ratio 0.069 0.106 0.066 0.063 0.029Adj. R-squared 0.103 0.017 0.009 0.099 0.138

Panel C. Hedging results for the third CDO intensity factorSPX Ret. -0.3873 -0.3392 -0.4433

(-5.61) (-4.33) (-5.33)∆Vol. 0.1690 0.0650 -0.0122

(3.65) (1.29) (-0.22)∆Smirk -0.1069 -0.1691

(-2.11) (-3.21)Constant 0.0015 0.0027 0.0015 0.0020 0.0014

(1.36) (2.28) (1.29) (1.69) (1.23)

Sharpe Ratio 0.097 0.162 0.092 0.120 0.088Adj. R-squared 0.133 0.058 0.017 0.136 0.175

47


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