Simulation of risk and return profiles for portfolios of CDO tranches

Investments in collateralized debt obligations (CDOs) often offer attractive yields relative to other similar debt instruments (corporate bonds, etc.). However, the risk profiles of CDO investments, and in particular portfolios of these investments, can be substantially different from straight credit portfolios due to complex correlation dependence across CDOs. Simulation is generally required to capture the intricate interaction of default and correlation risk that determines the risk and return profile of a portfolio of CDO investments. This paper considers some of the issues that must be addressed in determining the risk profiles with simulation and presents results on a simple example.