New model revolutionizes hedging for safer investments in CDOs.
The article discusses how to price and hedge single-tranche collateralized debt obligations (STCDOs) using a two-factor model that includes catastrophic risk. The model is based on real market data and uses a method called quasi-maximum likelihood estimation. The researchers found that the variance-minimizing strategy is most effective for mezzanine tranches in terms of reducing risk, but it doesn't work well for equity tranches.