Managing Synthetic CDO Tranches using Base Correlations
Managing Synthetic CDO Tranches using Base Correlations Managing Synthetic CDO Tranches using Base Correlations
So which stress test makes sense Is the base correlation moving in the wrong direction Base correlation explains the unexpected movement in prices In the actual market scenario (July 25-26), the Gaussian copula model overestimates the losses Adjust model by increasing correlation In fact, during this period of systemic risk, investors sold equity protection and bought index protection. This pushed base correlations up Hedging contributed to increased volatility (and accentuated spread widening) Hedge ratios broke down in high volatility environment Models used by dealers underestimated tranche deltas. Dealers rebalanced hedge ratios by buying index protection (to hedge bought mezzanine protection) CPDO (constant proportion debt obligations): as index spread widened, dealers needed to buy protection 20
Base correlation as a risk factor Volatility versus price level iTraxx Europe (Jan-05 to Sept-07) Vol from absolute difference Vol from relative difference 0.025 0.1 0.09 0.02 0.08 0.07 0.015 0.06 0.01 0.005 0.05 0.04 0.03 0.02 0 0.1 0.15 0.2 0.25 0.01 0.1 0.15 0.2 0.25 21
- Page 2 and 3: Managing synthetic CDO tranches usi
- Page 4 and 5: Synthetic CDO mechanics losses Pro
- Page 6 and 7: Protection buyer can hedge by selli
- Page 8 and 9: Agenda Synthetic CDO mechanics Ba
- Page 10 and 11: Gaussian Copula Model (con’t) S
- Page 12 and 13: Base correlation framework Each tr
- Page 14 and 15: Stress tests Base correlations c
- Page 16 and 17: Subprime crisis has spread to … L
- Page 18 and 19: Stress Test Example for CDX.NA.IG S
- Page 22 and 23: Agenda Synthetic CDO mechanics Ba
- Page 24 and 25: Mapping base correlations between b
- Page 26 and 27: Base correlation mapping methods Fi
- Page 28 and 29: Method 4: Expected Tranche Loss Pro
- Page 30 and 31: Comparison of mappings for iTraxx S
- Page 32 and 33: Heterogeneous portfolios Can we fin
- Page 34 and 35: Consider linear interpolation iTrax
- Page 36: Summary Base correlation are usef
So which stress test makes sense<br />
<br />
Is the base correlation moving in the wrong direction<br />
<strong>Base</strong> correlation explains the unexpected movement in prices<br />
In the actual market scenario (July 25-26), the Gaussian copula model<br />
overestimates the losses<br />
Adjust model by increasing correlation<br />
In fact, during this period of systemic risk, investors sold equity protection and<br />
bought index protection.<br />
This pushed base correlations up<br />
<br />
Hedging contributed to increased volatility (and accentuated spread widening)<br />
Hedge ratios broke down in high volatility environment<br />
Models used by dealers underestimated tranche deltas. Dealers rebalanced hedge<br />
ratios by buying index protection (to hedge bought mezzanine protection)<br />
CPDO (constant proportion debt obligations): as index spread widened, dealers<br />
needed to buy protection<br />
20
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