As to the risk-management capabilities of these nonbank entities, the study found that they seem largely aware of the risks associated with credit derivatives. The study did note that understanding the credit risk profile of CDO tranches poses challenges to even the most-sophisticated market participants. An especially difficult issue is the assessment of default correlation across different reference entities.
In general, the valuation of CDO tranches is model dependent, and market participants need to carefully evaluate the models that they use and the model parameter assumptions that they make, notably the assumptions regarding default correlations. To limit legal and reputational risks, dealers should seek to foster a complete understanding of transactions among the investors to which they sell CDO products.