Credit trade description & modelling issues

[Hardy Noman]

Hello David / Shakti,

in the readings (Malz Chapter 11) there is an example of a CDS strategy;

--> Sell Protection on equity tranche + buy protection on mezzanine tranche
i.e Long credit and credit spread risk of the equity tranche + short credit and credit spread risk on the mezzanine tranche

they say the motivation of the trade was to have a positive convex payoff profile with 2 positions benefitting from credit spread volatility, while earning a positive net spread on the positions.

HOW would this be possible....i mean how would this create a position similar to option straddle on credit spreads (with an option premium paid to the owner of the option)

Can you please explain the process/ strategy....this seems quite miraculous..! haha.

Thank you.
Hardy.

 

[ShaktiRathore]

hi,
This i think is for high volatility of credit spread. The sell on equity tranche protection premium is greater than buy on mezzanine tranche thus earning a net spread as equity tranche is more likely to default than mezzanine tranche and thus should earn more premium. Due to high volatility, Suppose that credit spread slides downwards than its very unlikely for equity tranche to default as well as obviously the mezzanine tranche to default is unlikely(mezzanine is just next to equity tranche in tranche structure), so premium spread earned preserved. Due to high volatility the credit spread slides upwards in that case both tranches are likely to default so it evens out on protection side and there is nil payoff but there is still premium spread earned preserved. I am not saying that spread remains such that equity tranche will default but not the mezzanine that is special case. Thus there is convex payoff with wild volatility swings but moderate volatility swings can led to losses if that is on upside. But overall there is benefit from wild volatility swings. Thus the two positions benefits from these wild volatility swings.


thanks

 

[Hardy Noman]

Thank you Shakti.

Reading your explanation...gave me a sudden blow of wisdom.

im not sure if this is right, but i think since these securities are MBS....so they have negative convexity at lower yields / CREDIT SPREADS.
While all of the different tranches would have a different credit spread & they would fall on different points on the convexity curve.
While the lower part (left) of the Price- credit spread curve has negative convexity (just like P/Y curve of an MBS)....and the upper part (right) has positive convexity...(coz less chances of it being prepayed...so just like a normal bond P/Y Curve)

When we short the Mezzanine tranche....its in the negative convexity area of the Price - Credit spread Curve...due to lowe credit spreads (compared to equity)
while the long Equity tranche must be in the positive area of the convexity curve (since it has higher credit spread its more to the right side of the Price - Credit spread curve..., which is the positive convexity side..)

While we are long Positive convexity and short Negative convexity (which effects into positive Convexity)
when credit spreads Increase....the decrease in value of the equity (which decreases at a decreasing rate...due to +ve convexity)...IS LESS THAN the Increase in value of the mezzanine tranche (coz its shorted) (decrease at an increasing rate....which is profitable for us, since we have shorted it)

the similar scenario occurs when credit spreads decrease...and we get a net profit.

This seems like a good strategy....pls lemme know if this thought process is correct

Thanks a million