Managing Synthetic CDO Tranches using Base Correlations

Stress tests
Base correlations can be stressed directly or indirectly
Indirect stresses involve market observables:
Upfront fee of equity and junior tranches
Tranche fair spreads
Stresses should propagate up the capital structure
Each stress shift involving market quotes is translated into a base correlation shift
Example:
0-3% Upfront fee increases bootstrap: calculate ρ 3
’
3-7% Tranche fair spread increases bootstrap: calculate ρ 7
’(use ρ 3
’)
7-10% No stress is applied bootstrap: ρ 10
’(use ρ 7
’)
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