Describe Debt Obligations of European Small and Medium-sized Enterprises
The distinct nature of SMEs makes the pricing and structuring of SME CDO products particularly difficult. First of all, SMEs are openly unrated causing information moral and asymmetries hazard complexities within the SME CDO market.
The issue of how to price SME CDOs should get special attention by the quantitative analysts, in the similar way that the SMEs are treated differently relatively to large enterprises under the new Capital Accord. For instance, there is a smaller risk weight factor for economic capital when the bank’s exposure is coming from an SME than a large firm.
Therefore, this research paper is devoted completely to the pricing of SME CDOs, aiming at contributing to the studies of the SME debt securitization from both a qualitative and quantitative perspective. In specific, the SME CDO pricing framework of this research paper has been prepared in such a way as to provide an intuitive and flexible way of pricing those instruments. It shows a genuine extension to the area of SME structured finance of the quantitative methods in Albanese, Chen, Vidler and Dalessandro (2006).
This research paper develops a framework for pricing synthetic tranches of collateralized debt obligations (CDOs) backed by loans to medium and small -sized enterprises (SMEs). By using functional calculus the pricing of SME CDOs is done in the light of a constructive, intuitive approach and functional analytic, while it overcomes the Monte Carlo simulation noise of copula implementation schemes. In addition, the functional calculus framework is flexible and rich enough to accommodate both jumps and dynamic correlation structures within the credit quality process of the SME obligors and therefore the CDO pricing kernel.
Thus, the mathematical components enter the pricing framework in an intuitive way. Initially, the construction of the Credit Barrier Model (CBM) satisfies both the fundamental theorem of finance and the theorem of measure changes. Secondly, the pricing framework is justified from an economic perspective, by taking on board special issues arising in the SME structured finance. For instance, the complex correlation interrelationships of the SMEs with large financial and enterprises observables and the fact that the asset side of an SME CDO consists of hundreds names.
The calibration is performed under both the risk-neutral (pricing) and statistical (real-world) measure. Under the statistical evaluate the model is calibrated by using historical credit ratings data for SMEs at the aggregate level. Then, the CBM and the dynamic correlation methods are combined to price an actual SME synthetic CDO from the German securitization market. The pricing and the evaluation of the various hedge ratios of the different tranches with or without trading management constraints (unwind constraints) has been successful.
