Factor Distributions Implied by Quoted CDO Spreads Tranche Pricing

The rapid pace of innovation in the market for credit risk has given rise to a liquid market in synthetic collateralised debt obligation (CDO) tranches on standardised portfolios. To the extent that tranche spreads depend on default dependence between different obligors in the reference portfolio, quoted spreads can be seen as aggregating the market views on this dependence. In a manner reminiscent of the volatility smiles found in liquid option markets, practitioners speak of implied correlation “smiles” and “skews”. We explore how this analogy can be taken a step further to extract implied factor distributions from the market quotes for synthetic CDO tranches.