Former Lehman researchers team up on arb-free cash CLO model

Two quants who worked together at Lehman Brothers immediately prior to its collapse have published what they believe is the first top-down, risk-neutral model for pricing cashflow CLOs. Yadong Li and Ziyu Zheng’s paper – see A Top-Down Model for Cash CLOs – is based in large part on work they carried out at Lehman Brothers, which was the biggest arranger of loan-backed CSOs such as the Exum Ridge deal, and which was keen to find ways to compare prices of these synthetic tranches with tranches of traditional cashflow deals.

The model makes no attempt to derive a CLO tranche valuation from the price of individual loans since, as the authors point out, there is no strong arbitrage relationship between the price of the underlying assets and those of the CLO tranches.

Instead, it takes an approach somewhat similar to CSO pricing models. However, instead of using a credit derivative index such as CDX as an input, the analysts suggest deriving prices from a hypothetical, liquid “index CLO”. They suggest that dealers work together to come up with a set of several standard market scenarios, and use them to price a handful of index CLOs. These prices can then be used as the basis for pricing all other CLOs.

Li remains in a similar role at Barclays Capital in New York, while Zheng is head of model risk research at Morgan Stanley.