Monday, July 30, 2007

CDS: correlation crisis

--mezzanine-hedged equity strategies backfired in May 2005. Because the tot spread changes across all tranches must add up to the index level (e.g CDX IG spread). So when equity tranches spread widen, mezzanine might actually tighten. --double loss: hedge funds and dealers take positions of buying protection on senior tranche while selling protection on CDX index. But when both positions are working against (tranche spread tighten and CDX index spread widen) them, the loss will accerlate because they have to reduce the hedging position by unwinding buying protection on CDX index, resulting wider CDX Index spread.

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