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.
The week on Risk.net, August 19-25, 2016Receive this by email