hard · FRM Part 2 Credit Risk
A bank securitizes $2 billion of corporate loans into three tranches: Equity (0-5%), Mezzanine (5-12%), and Senior (12-100%).
Which tranche is considered 'Long Correlation' and why?
- The Senior tranche; it benefits when defaults are highly correlated because it is structurally protected against everything except idiosyncratic, firm-specific risk.
- The Mezzanine tranche; its value is largely insensitive to correlation since it mainly depends on the underlying pool's overall average default rate, denoted lambda.
- All tranches are equally short correlation, because the total expected loss generated by the underlying pool of corporate loans is independent of the correlation structure among names.
- The Equity tranche; it benefits when defaults cluster (high correlation) because the first few defaults wipe out the tranche regardless of whether they are correlated or not.
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