1
$\begingroup$

I think there is an error in the Meissner text - Correlation Risk Modeling and Management and can't find an errata for this text to verify.

On page 19 the foot note reads:

  1. Shorting the equity tranche means being short credit protection or selling credit protection, which means receiving the (high) equity tranche contract spread

In the context, he is talking about CDOs, which makes me think this is incorrect. In a CDO, doesn't being short a tranche buy credit protection and investing in the tranche (long) is to sell credit protection?

When you invest in one of the tranches of a CDO, you are exposed to credit risk which is why you are compensated by a spread right ?

| improve this question | |
$\endgroup$
  • $\begingroup$ In most of the case, a CDO is synthetic. That is, we do not invest in the tranche directly, but only long or short the credit protection on the tranches. $\endgroup$ – Gordon Dec 15 '15 at 19:15
1
$\begingroup$

investor interest in cash cdo tranches is driven by gaining [leveraged] credit exposure; in cash cdo investor goes long credit exposure and statement "going long tranche implies short exposure (i.e. buy credit protection)" is questionable.

synthetic: Entity which issues cdo may sell cds and collect premiums; these premiums are further distributed to pay investors in cdo tranches - effectively investors are going short cds (long credit exposure) and collect coupons for doing so. Going long the tranche is effectively long credit exposure (short cds); and going short the tranche is effectively short credit exposure (buy cds).

credit protection = short credit exposure

short (credit protection) = short (short credit exposure) = long credit exposure

hope this helps

| improve this answer | |
$\endgroup$
  • $\begingroup$ Thanks for your reply, but I can't follow what you're trying to say. $\endgroup$ – AfterWorkGuinness Nov 15 '15 at 21:13
  • $\begingroup$ i wanted to say shorting the tranche mean short expsure (effectively long protection and the author's statement seems incorrect. Moreover on the same page 19-20 author's sentences Hedge funds had shorted the equity tranche collect the high equity tranche spread. They had then presumably hedged the risk by going long the mezzanine tranche. seems to be missing the point, as the big trade was long equity tranche and short mezzanine. $\endgroup$ – Nicholas Nov 17 '15 at 0:43
  • $\begingroup$ and the way hedge fund were achieving such exposure was via short protection on equity tranche (not short the tranche) and buy protection on mezz. For more info about equity vs mezz trade have a look here, page 50 and here $\endgroup$ – Nicholas Nov 17 '15 at 0:56

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.