Correlation during Financial Crisis
- Thread starter nirmal010
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This is explained extensively under the Meissner related posts (assuming you are referring to the CDO Equity Mezz trade).
A search of equity mezzanine will identify some...
Note, however, that the Meissner text has a few errors that made the concept difficult for many..... the posts here in BT will explain.
Hi @nirmal010 We've recently discussed this here at https://forum.bionicturtle.com/threads/short-equity-t-long-mezzannine-t-correlation-impact.10203/ (which further links to prior posts, including https://forum.bionicturtle.com/thre...anagement-meissner-chapter-1.8207/#post-43056)
My (best efforts) regarding the hedge funds intuition is "... it looks like the hedge funds under consideration wrote CDS (sold credit protection) on the CDO equity tranche and, in an attempt to hedge, bought CDS (bought credit protection) on the CDO mezz tranche expecting them to react similarly to correlation shifts. If the mezzanine position was a hedge, they must have expected the mezzanine trance to react to lower correlation in a way similar to the equity: they expected lower default correlation to associate with higher spreads (lower value). But it acted more like a senior tranche." ... keep in mind the only difference here is between 0 to 3% (equity) and 3 to 7% (mezzanine). I might be inclined to think of 0 to 7% as equity
It's not like the mezzanine was 15 to 20% ...
My (best efforts) regarding the hedge funds intuition is "... it looks like the hedge funds under consideration wrote CDS (sold credit protection) on the CDO equity tranche and, in an attempt to hedge, bought CDS (bought credit protection) on the CDO mezz tranche expecting them to react similarly to correlation shifts. If the mezzanine position was a hedge, they must have expected the mezzanine trance to react to lower correlation in a way similar to the equity: they expected lower default correlation to associate with higher spreads (lower value). But it acted more like a senior tranche." ... keep in mind the only difference here is between 0 to 3% (equity) and 3 to 7% (mezzanine). I might be inclined to think of 0 to 7% as equity
It's not like the mezzanine was 15 to 20% ...
Hi!
Again, about correlations during the recent financial crisis, it says "Rating agencies downgraded GM and Ford to junk bond status. Following the change in bond ratings, the equity tranche spread increased dramatically. This caused losses on the short equity tranche position. At the same time, the correlations decreased for CDOs of investment grade bonds. The lower correlations in the mezzanıne tranche led to losses in the mezzanıne tranche."
Now, I am completely confused about why it caused losses on the short position and the correlation decreased for CDOs of investment grade bonds. That means the value of equity tranche increases but i guess it must have decreased because they were junk bonds and the spread increased. How does the mechanism work here? Thank you.
Again, about correlations during the recent financial crisis, it says "Rating agencies downgraded GM and Ford to junk bond status. Following the change in bond ratings, the equity tranche spread increased dramatically. This caused losses on the short equity tranche position. At the same time, the correlations decreased for CDOs of investment grade bonds. The lower correlations in the mezzanıne tranche led to losses in the mezzanıne tranche."
Now, I am completely confused about why it caused losses on the short position and the correlation decreased for CDOs of investment grade bonds. That means the value of equity tranche increases but i guess it must have decreased because they were junk bonds and the spread increased. How does the mechanism work here? Thank you.
I am interested too since the lower correlations would imply that the equity trance would decrease froma long position perspective.
I am also interested in how "Hedge funds had shorted the equity tranche (0% to 3% in Figure 1.7) to collect the high equity tranche spread. They had then presumably hedged the risk by going long the mezzanine tranche (3% to 7% in Figure 1.7)."
If I am trying to collect a spread, wouldn't I want to be long the equity tranche with a higher spread and short the mezzanine which has a lower spread? To me, it seems like shorting the tranche with the higher spread would result in a negative net spread In this example, the equity tranche spread (0-3%) is lower than the mezzanine (3-7%) - how is this the case??
EDIT: N/m i figured it out. The %s listed in the confusing chart is not the % of interest your received, these are % of default protection. So in this example, the equity tranche absorbs the first 0-3% of losses and the mezz 3-7%. Lower correlation means lower PD, which is a gain for the long equity trance and loss for short equity tranche. The mezz incurs a loss because they are long credit protection but it becomes worthless when correlation decreases.
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@omerozd @bpdulog we discussed this is much detail here https://forum.bionicturtle.com/threads/short-equity-t-long-mezzannine-t-correlation-impact.10203/
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