Need helps on Q35.6 in T6 notes.

[FRMStrawberry]

Hi David,

I am a little confused by this question. And I think there is a similar question in Nov-2012 Part II exam.So I would like to know if you can explain in more details about the default correlation and risk of different tranches in a pool.

Regards.

 

[David Harper CFA FRM]

Hi FRMStrawberry

If you search "default correlation," you'll see this has been discussed for years. The easiest way to start to grasp it (imo) is with a classic binomial. For example:

Assume 10 credits in a basket CDS, 1% PD each

In regard to the equity tranche:

• If correlation = 0, what is prob[trigger a 1st-to-default; equity tranche]? it is 1 - [prob none default] = 1-99%^10 = 9.56%
• If correlation increases to 1.0, prob [trigger a 12D] goes down to 1.0%; Malz says "equity tranches prefer higher correlation"

For senior tranche, consider a 10th-to-default (triggers only if all 10 credits default):

• if correlation = 1.0, prob[all default] = 1.0%
• if correlation = 0.0, prob[all default] = 1%^10 = basically zero; Malz says "senior tranches are driven by lower correlation"

For more, see
http://forum.bionicturtle.com/threads/bt2012-p2-07-securitization-tranches.5756
http://forum.bionicturtle.com/threads/basket-tranches-value-and-risk.5901/
http://forum.bionicturtle.com/threads/2012-practice-exam-p2-8-cdo-tranches.5775/

I hope that helps, thanks,