credit risk-impact of correlations on various CDS tranches

Posts: 1
Joined: Sat May 05, 2012 12:25 pm

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?


Finance Junkie
Posts: 356
Joined: Wed Apr 11, 2012 11:26 am

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-)

Return to “FRM Part II”


Global Association of Risk Professionals, Inc. (GARP®) does not endorse, promote, review or warrant the accuracy of the products or services offered by EduPristine for FRM® related information, nor does it endorse any pass rates claimed by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to EduPristine nor is GARP® responsible for any fees or costs of any person or entity providing any services to EduPristine Study Program. FRM®, GARP® and Global Association of Risk Professionals®, are trademarks owned by the Global Association of Risk Professionals, Inc

CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by EduPristine. CFA Institute, CFA®, Claritas® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

Utmost care has been taken to ensure that there is no copyright violation or infringement in any of our content. Still, in case you feel that there is any copyright violation of any kind please send a mail to and we will rectify it.