Course Errors Found in 2021/2022 Study Materials P2.T5. Market Risk

[Shau_2207]

Hello David,

Can you please confirm if the mentioned hedge fund Strategy correct?

I think its flipped,
1) Long Equity Tranche CDO=> Decreased correlation => Spreads widen (instead of expected tighten ie becoming better-off ) => Loose money
2) Short Mezzanine tranche CDO => Decreased correlation => Spreads Tighten ( Instead of expected widen ie becoming worse -off) => Loose money.

 

[David Harper CFA FRM]

Hi @Shau_2207 I think maybe you are correct, but any cursory search of this forum will show we've discussed it extensively over the years such that I wrote Gunter for clarification ("apparently you CORRECTED this in the second edition.") but he didn't respond. Here's what I wrote https://forum.bionicturtle.com/thre...zannine-t-correlation-impact.10203/post-90427 with (for example) links to

• https://forum.bionicturtle.com/thre...management-meissner-chapter-1.8207/post-47639
• https://forum.bionicturtle.com/thre...t-to-correlation-between-assets-in-cdo.24174/

 

[Shau_2207]

Thank you David for your prompt reply!

I think both the points are correct (in a way!) in Gunter's edition. It's just the interpretation

Please let me know if this is correct.

Here Interpretation is that its a basket CDS / CDS index:-

1) Short Equity Tranche - Short CDS (Short risk) Sold CDS we are expecting (underlying ) credit quality becoming better off in equity tranche CDX => as Correlation decrease =>(CDS) Spreads Widen ie Underlying credit quality becoming worse off => Lose Money

2) Long Mezzanine Tranche - Long CDS (Long Risk) bought CDS we are expecting (underlying) credit quality becoming worse off in Mezzanine Tranche CDX => as Correlation decrease => Spreads Tighten ie Underlying credit quality becoming better off => Lose Money

Here Interpretation is that its a basket of bonds with same credit quality in each tranche:-

1) Long Equity Tranche - We are expecting the bonds in the basket becoming better off ie (spreads tighten) but instead when correlation decreases (bond) spreads Increases (Widen) => Lose Money

2) Short Mezzanine Tranche- We are expecting the bonds in the basket becoming worse off ie (Spreads) Widen => but instead when correlation decreases (bond) spreads decreased (Tighten) => Lose Money

In summary; in one edition he is assuming (i guess) credit protection and another one he is assuming underlying ie bond.