Vanessa Sternbeck Fryxell and Malin Norberg

Trading correlated credit during a financial crisis

Abstract

The market of CDOs blossomed for several years but when the financial crisis 
became a fact in 2008 the market became increasingly turbulent resulting in a 
large decline in the trade of CDOs. Criticism has been leveled against the 
valuation models for CDOs, and primarily against the Gaussian copula model 
that for years has been the market standard pricing model. 

The objective of this thesis is to examine the market standard model for 
valuation of CDOs as well as more sophisticated models. The purpose of the 
evaluation of CDOs and their valuation models is to shed light on their 
shortcomings and thereby their role in the financial crisis. 

From our results, it is visible that both the market standard model and more 
sophisticated models give rise to mispricing in crisis times. The problem of 
valuation models for CDOs is the difficulties of reflecting the actual risk 
properly with the consequence of people taking on more risk than intended. 
Consequently, the models have, if not created, enhanced the magnitude of the 
financial crisis.