What a CDO simulation teaches us about correlated credit risk
Why diversification can appear robust until the dependence structure—and the tranche waterfall—begins to matter.
In structured credit, the expected number of defaults tells only part of the story. The timing and correlation of defaults determine who absorbs losses and how quickly protection disappears.
Correlation changes the shape of loss
Independent defaults tend to distribute losses more smoothly. Positive correlation creates more paths with either very few defaults or concentrated waves of defaults, thickening the portfolio-loss tail.
That distinction is crucial because tranches do not respond linearly to portfolio loss.
The waterfall creates asymmetric exposure
Equity absorbs losses first and earns the residual spread. Senior investors appear protected by subordination, but their loss distribution can change sharply once systemic scenarios overwhelm the junior structure.
Simulation is a thinking tool
A Monte Carlo engine does more than produce a price. It lets us inspect which assumptions create risk: default intensity, recovery, dependence, attachment points, and the timing of cash flows.