European Securitisation: A GARCH Model of CDO, MBS and Pfandbrief Spreads

Asset-backed securitisation (ABS) is an asset funding technique that involvesthe issuance of structured claims on the cash flow performance of a designatedpool of underlying receivables. Efficient risk management and asset allocation inthis growing segment of fixed income markets requires both investors andissuers to thoroughly understand the longitudinal properties of spread prices.We present a multi-factor GARCH process in order to model theheteroskedasticity of secondary market spreads for valuation and forecastingpurposes. In particular, accounting for the variance of errors is instrumental inderiving more accurate estimators of time-varying forecast confidence intervals.On the basis of CDO, MBS and Pfandbrief transactions as the most importantasset classes of off-balance sheet and on-balance sheet securitisation in Europewe find that expected spread changes for these asset classes tends to be levelstationary with model estimates indicating asymmetric mean reversion.Furthermore, spread volatility (conditional variance) is found to follow anasymmetric stochastic process contingent on the value of past residuals. ThisABS spread behaviour implies negative investor sentiment during cyclicaldownturns, which is likely to escape stationary approximation the longer thismarket situation lasts.