In the additional reading section on the IFoA, I came across a doc on credit derivatives. In the section about impact of implied correlation on the various tranches, there is an illustration for 3 tranches and various values. It shows, the super senior tranche reduces in value when the implied correlation increases, that I can understand. But it says the spread payable n equities decreases as correlation increases. I thought that should be the other way round too!! My understanding was this ...if correlation in the collateral portfolio increases, the probability of joint defaults would increase, hence more risky the various tranches that are backed by this collateral portfolio. Now what do they mean by spread payable on equities? How does that reduce when correlation rises?
I dont have the doc itself here, but from your description I would tend to agree with you. If correlations increase, everything gets riskier, ie the credit spread on all tranches would widen. Maybe the top tranches widen more than the lower tranches (which are already quite risky) and hence the difference between the equity tranche and the next up reduces?? Anyone else got a view here?
It is very sensible here. It is well understood that as the correlation of default increases, the senior tranches lose value (probability that they will have to share losses with junior tranches increases), and the equity tranche will gain in value (for the same reason that losses now will be shared with tranches up in seniority). This also implies that the credit risk spread must widen for the senior tranches (the investors will demand higher compensation for the increased risk), while for the equity tranches, it should decline from its already high level of risk spread- now that it will behave more in sync with senior tranches, the spreads should converge to a common value
