Implications of Stochastic Recovery Rates in Evaluating CDO Tranches

The binomial expansion technique originally proposed by Moody9s has been widely adopted as the standard technique for assessing the risk of CBO/CLO tranches. The key assumption underlying it is the non-variability of recovery rates. A comparison with the results produced by Monte Carlo simulation assuming stochastic recovery rates indicates rating differentials of up to five rating notches in ratings of CBO/CLO tranches that are attributable to the recovery rate assumption. Some adjustments to constant recovery rates would make the ratings indicated by the BET more consistent with the results of Monte Carlo simulation.