High Correlation Favors Equity in Structured Credit Vehicles

[brian.field]

It is often suggested that, ceteris paribus, higher correlation favors equity over debt and lower correlation favors debt over equity.

It is interesting, then, that the illustration Malz provides on page 324 shows the highest equity return occurs with a 0.00 correlation scenario and decreases as the correlation moves from 0.00 to 0.30 and then to from 0.30 to 0.60.

The equity return then increases as correlation increases from 0.60 to 0.90.

Brian

 

[ShaktiRathore]

Regarding first point,
It seems logical that higher correlation makes equity similar to debt in terms of risk but equity provides higher return than debt therefore more favorable and a lower correlation means equity more risky than debt and provided same equity returns the debt becomes more favorable.
Second point i think is more to do with corr of equity return and corelation rather than choice b/w equity and debt as correlation changes. At 0 correlation equity is most disimilar to debt therefore have highest risk than debt so highest return but as correlation increases the equity becomes more similar to debt and thus risk decreases as well as the return. As correlation increase the equity being similar in risk so when default occurs is last one to be paid should have higher return so return increases as corr moves towards 1.

Thanks