TBDS & Correlation between underlying assets

[rahul.goyl]

Hi David,
Need your help on the below, the answer for this is C. But not convinced though, why the negative correlation between assets will be increased risk for an investor.

Question:
You are considering an investment in the mezzanine tranche of a tranched basket default swap (TBDS) constructed from a basket of N assets. The TBDS is structured such that the junior tranche is exposed to the first four defaults, the mezzanine tranche to the fifth, sixth, seventh and eighth defaults, and the senior tranche to the ninth and higher defaults. The risk of this investment increases as:
Choose one answer.

a. The number of assets in the basket, N, decreases and the default correlation of the assets approaches becomes negative
b. The number of assets in the basket, N, increases and the default correlation of the assets becomes closer to zero.
c. The number of assets in the basket, N, increases and the default correlation of the assets becomes more negative.
d. The number of assets in the basket, N, decreases and the default correlation of the assets becomes closer to zero.

Thanks
Rahul

 

[David Harper CFA FRM]

Hi Rahul,

It's a bad question, last year I asked for it to be removed...IMO, your confusion is justified...
(e.g., same or something like it @ http://forum.bionicturtle.com/viewthread/813/#2027)

....we care about the assertions below, reflected in graphic from the tutorial; e.g., lower correlation increases risk of junior (1st to default) tranches.
see http://forum.bionicturtle.com/viewthread/571/

the *intent* of the question is to treat the mezzanine like a junior (1st to default), (and you'll note, as the number of credit's increases, the mezzanine becomes more like a 1st to default) but it's still bad: the mezzanine's reaction to default correlation is complex and could swing either way or be neutral. We generally make prima facia assertions only about the junior and senior...
(also answer b is awkward, half of the time, that's a decreasing correlation!)

David

http://learn.bionicturtle.com/images/forum/0911_defaultcorrelation.png

 

[[email protected]]

Hi David,

Given (c) is not an answer. The best answer will it be (b) as below?

b. The number of assets in the basket, N, increases and the default correlation of the assets becomes closer to zero.

Thanks.

Regards
Learning

 

[David Harper CFA FRM]

Hi Learning,

No, the best is (c), but IMO the question is flawed for its ignorance concerning the complexity of the mezzanine. As above, it means to treat the mezzanine like a junior/equity tranche. In that case, negative correlation increases risk of junior. If we imagine unrealistic -1.0 default correlation, then the 1st-to-default is guaranteed to default (something must default)...David

 

[sleepybird]

Hi David,
With regard to your chart: http://learn.bionicturtle.com/images/forum/0911_defaultcorrelation.png
I understand that lower correlation is beneficial to the senior/Nth-to-default tranches.
What about the # of credits (n)? If n increases, is it good or bad for senior/Nth to default tranches?
I can't seem to get it from the chart.
Much appreciate your clarification.
Sleepybird