Leveraged super-senior (LSS) trades represent a mechanism for packaging senior credit risk. Many LSS structures have been issued to date and yet there seems to be no formal pricing approach. In this article, Jon Gregory discusses the valuation of LSS protection in a model-independent framework. He argues that the 'equivalence' approach to pricing that seems widely used is not appropriate
The structured credit market has grown rapidly in recent years with the use of synthetic collateralised debt obligations (CDOs), which allow issuers to sell a particular tranche of a portfolio hedged with more simple instruments such as single-name credit default swaps. One problem in the early development of the CDO market was the fact that correlation was a key input to the pricing but was a rather opaque quantity. The development of the index tranche market in 2004 provided a solution to this problem of observability, and has led to correlation trading across the capital structure for corporate credit portfolios and other asset classes such as asset-backed securities (ABSs), leveraged loans and commercial mortgage-backed securities.
One feature of the correlation market is that senior risk trades at a significant risk premium. Take the iTraxx 22-100% tranche as an example. This portfolio, consisting of 125 investment-grade names, will require 40 credit events at 30% average recovery value before suffering any loss.1 Almost one-third of the portfolio needs to default before this tranche loses principal, and the likelihood of this might be considered negligible by market participants when taken into consideration alongside factors such as their own financial solvency.
More on Credit Derivatives
Association still faces licensing overhaul as part of pending settlement
Vladimir Piterbarg considers a non-linear partial differentiation equation that appears in a number of XVA-related contexts, including a one-way credit-support annex, credit value adjustment with ri...
Up to 10 new names from under-represented sectors could be added to high-yield CDX index
China's CDS market needs new structure if it is to win over investors
Sign up for Risk.net email alerts
Sanjay Sharma talks about risk transparency and how his book helps achieve it.
A five-minute formula from Alexander Denev that takes you through a simple probabilistic graphical model and explains how and why these are used. Find out more about the ground-breaking book, Probabilistic...
Industry leader Vincent Kaminski discusses the challenges faced by energy markets and his new book, Managing Energy Price Risk, 4th Edition.
Momtchil Pojarliev talks about his book, The Role of Currency in Institutional Portolios, currency investing and the potential role of currencies in institutional portfolios.
There are no comments submitted yet. Do you have an interesting opinion? Then be the first to post a comment.