Hidden Risks In The CDO - Squared Market

Abstract

We show that there are risks (default location risk and overlap risk) unique to CDO-squared structures. These risks may not be well-understood by investors and credit rating agencies. As a result, the tranche of a CDO-squared having the same name and similar rating to the tranche of a CDO may have a very different risk profile, and the returns offered to CDO-squared investors may be unattractive on a risk-adjusted basis. We believe that the hidden risks in CDO-squared structures will be clearly exposed in a distressed credit environment.