credit risk-impact of correlations on various CDS tranches

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credit risk-impact of correlations on various CDS tranches

Postby anumendiratta.a » Sat May 05, 2012 12:27 pm

1. You are considering an investment in the mezzanine tranche of a tranched basket default swap (TBDS) constructed from a basket of N assets. The TBDS is structured such that the junior tranche is exposed to the first four defaults, the mezzanine tranche to the fifth, sixth, seventh and eighth defaults, and the senior tranche to the ninth and higher defaults. The risk of this investment increases as:
Number of assets___________and default correlation of assets________
2.All else held constant, if the default correlations between the individual reference credit names are reduced from 1.0 to 0.7, what is the effect on the relationship between the junior tranche spread J and the senior tranche spread S?


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Re: credit risk-impact of correlations on various CDS tranch

Postby content.pristine » Tue May 08, 2012 12:21 am

Hi Anu,

1) Increases (as number of the sample increases, the probability that 1 (or N) would default would increase, Increases (increasing correlation would mean increasing the chances that if one defaults then more would also default)
2) If the correlations of defaults was a perfect 1, then theoretically, the risk for the junior and senior tranche should be exactly the same. (This would be because if one guy defaulted then everyone else in the basket would also default).For example, lets say their spread was 8% (or 800 bps). Now, when the correlations drop to 0.7, the risk decreases for both. Now, the question is "to what extent would it decrease for the senior and the junior?". The senior's tranche's spread would decrease to a higher extent than that of the junior tranche. Therefore, the spread between junior and senior tranche's increase.

The takeaway here is that high correlations are risky and would demand a higher spread than that with lower correlations.

Hope this helps 8-)

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