CDO tranches & call option

[shlo8134]

Hi. In the study notes of the assigned reading "Innovations in Credit Risk Transfer: Implications for Financial Stability" by Darrell Duffie (p.27) says

Senior CDO tranche is shorting a call option on cash-flow of underlying collateral, while
Junior tranche is effectively long a call option on cash flows.

Could anyone please explain why it is so? Thank you.

 

[David Harper CFA FRM]

Hi shlo8134,

I think he means: imagine a CDO/basket CDS with 100 credits, each contributing cash flow (waterfall) of $1. Say junior (equity) tranche is the first 10%. This tranche is exposed to the cash flow performance: if no defaults, receives 10*$1 = $10. If 10 defaults, pays zero. In this way, you are "long" the $10 cash flow as you are betting the basket will experience little/no default. On the other hand, if you do expect some defaults, you'd buy the senior tranche. I think, but am frankly unsure, that he means something like "I expect impaired cash flow [I am short the cash flow], so I will buy the more protected tranches"

However, I may lack his full understanding b/c personally find that a bit loose: both tranches are writing (short) options as they collect yield (premium) in exchange for the SPV's option to withhold cash in the event of defaults (where the difference is primarily where to set the strike price; the junior tranche is paid more to write an put option with "high" strike, the senior is paid less to write a put with a "low" strike. This is how i would characterize the tranches.)

I copy his full paragraph below because when he refers to correlation, that is the more common way to characterize: the junior tranche is LONG correlation (i.e., he/she would prefer perfect correlation as that increases the odds of no defaults) while the senior tranche is SHORT correlation (low correlations virtually ensures that the entire structure cannot default)

"A senior CDO tranche is effectively "short a call option" on the cash-ow performance of the underlying collateral pool. The market value of a senior tranche therefore decreases with risk neutral default correlation. The value of the equity piece, which resembles a call option on the collateral pool cash flows, increases with default correlation. Optionality does not have a clear effect on the valuation of intermediate tranches, however. Each of the intermediate tranches has given up an option to the tranches with less priority and taken an option from the tranches above it. The overcollateralisation of a tranche is the principal amount of debt below it. With sufficient overcollateralisation, the option given to the lower tranches dominates, but it is the other way around for sufficiently low levels of overcollateralisation."

David