Correlation Breakdown in the Valuation of Collateralized Fund Obligation

Abstract

In a collateralized fund obligation (CFO) several hedge funds are pooled in a fund that is in turn, securitized. Since the first securitization of a fund of hedge funds, launched in June 2002, these products haven't had much impact among investors. This is not surprising considering that it is very difficult to predict the credit solvency of each tranche of the securitization and therefore its valuation. In this article a particular CFO is analyzed in an analytical pricing framework, capturing the correlation breakdown and the leptokurtic phenomena characteristics of hedge funds. The results show that due to a lack of transparency which is common in hedge funds, confidence intervals in probabilities of default and credit spreads, are high enough to burden CFO proliferation.