The CDO Equity

Abstract

Interest in CDO equity continues to grow along with its variety and complexity. Firms engaged in manufacturing CDO equity are attempting to broaden its distribution among alternative investors, including endowments, foundations, and pension funds as well as ultra-high-net-worth investors. This article describes CDO equity as an alternative asset belonging to a separate class of alternative investments (structured product), subject to certain qualifications. It discusses CDO equity as an option on the underlying assets, outlines the correlation and other investment properties of both dynamic and static CDO equity, and illustrates such properties through examples. The article uses the option framework developed by Merton and Black and Scholes to determine the valuation of CDO equity as a call option on the CDO assets. Furthermore, it provides a guideline for investment in CDO equity from an asset allocation perspective. The author believes that CDO equity should serve as a risk-diversifier to alternative portfolios with attractive returns.