Meissner, Chapter 1: Some Correlation Basics

[Stuti]

Hi @David Harper CFA FRM,

While going through the chapter I have a couple of questions:

1. Quanto Option - In the reading it mentions -

1. If the correlation is positive, an increasing Nikkei will mean an increasing yen. That is favorable for the call seller. She has to settle the payoff, but only needs a small yen amount to achieve the dollar payment.
   Can you please elaborate on the reasoning?

2. The first “correlation-related crisis:” - CDO & Correlation

• When the correlations of the assets in the CDO decreased, the hedge funds lost on both positions. Are we referring to default correlation here or asset correlations? How did the correlation decreased if the bonds were downgraded to junk status? Are we saying that since other bonds were investment grade and Ford and GM were junk, there will be negative correlation between them and hence the correlation decreased?
  
  1. The equity tranche spread increased sharply; see arrow 1. Hence the fixed spread that the hedge funds received in the original transaction was now significantly lower than the current market spread, resulting in a paper loss. Can you please explain why did the equity tranche spread increased?
     
     
  2. The hedge funds lost on their long mezzanine tranche positions, since a lower correlation lowers the mezzanine tranche spread; see arrow 2. The spread that the hedge funds paid in the original transactions was now higher than the market spread, resulting in another paper loss. Can you please explain why did the mezzanine tranche spread decrease?
     

Thanks

 

[bpdulog]

Hi @David Harper CFA FRM,

While going through the chapter I have a couple of questions:

1. Quanto Option - In the reading it mentions -

1. If the correlation is positive, an increasing Nikkei will mean an increasing yen. That is favorable for the call seller. She has to settle the payoff, but only needs a small yen amount to achieve the dollar payment.
   Can you please elaborate on the reasoning?

2. The first “correlation-related crisis:” - CDO & Correlation

• When the correlations of the assets in the CDO decreased, the hedge funds lost on both positions. Are we referring to default correlation here or asset correlations? How did the correlation decreased if the bonds were downgraded to junk status? Are we saying that since other bonds were investment grade and Ford and GM were junk, there will be negative correlation between them and hence the correlation decreased?
  1. The equity tranche spread increased sharply; see arrow 1. Hence the fixed spread that the hedge funds received in the original transaction was now significantly lower than the current market spread, resulting in a paper loss. Can you please explain why did the equity tranche spread increased?
     
     
  2. The hedge funds lost on their long mezzanine tranche positions, since a lower correlation lowers the mezzanine tranche spread; see arrow 2. The spread that the hedge funds paid in the original transactions was now higher than the market spread, resulting in another paper loss. Can you please explain why did the mezzanine tranche spread decrease?

Thanks

For 2.,

The spread decreased because as a purchaser of mezz tranche you are buying credit protection (for 0-3% default in this case) . If correlations decrease, the value of that protection goes down and becomes more worthless as correlation decreases