Operational Risk-MALZ Case Study-2005 Credit Correlation Episode.

[wanderer87]

Hi David,

I am unable to understand the case study.Can you please explain how it was supposed to earn money?.

Also,
It says it was a long credit risk on equity , meaning it would benefit by an increase in credit risk on equity, but as they had sold protection on equity they would have to pay in case of default, so they would loose ?

Also it says that the trade benefits from changes in default rate in either direction , how is that?

 

[David Harper CFA FRM]

Hi @wanderer87 I will need to bookmark and address this question when I get to the notes revision of Malz. Sorry, I just don't have a immediate recollection (and I need to edit notes and PQ docs in the short run). Thanks for understanding, hopefully somebody has an answer

 

[afterworkguinness]

Hi @Wanderer, they were attempting to create a straddle like position, similar to how you would with options. This strategy is used when you want to benefit from moves in the underlying, but are not sure what direction they will go. Here is a good definition of straddle: http://www.investopedia.com/terms/s/straddle.asp

The trade was long the equity tranche (reminder with CDS indexes, long = sell protection = long credit risk. Similar exposure to holding a bond), as the probability of default increased the premium they collected would increase, but yes, as you pointed out so would the probability of them having to make a payment.

The problem with the trade was not because it was long equity tranche and short mezz tranche, that's a common trade. The problem was, they failed to account for changes in the default correlation...the correlation between the different credits in the basket defaulting. When correlation began to change, they should have adjusted their hedged (shorted more of the mezz tranche for protection), but they didn't.