Tuesday, November 08, 2005

Index and Bespoken Tranches

In the credit derivatives trading system we are building, we need to add support for various structured products. Two of the products are index and bespoken tranches. Other instruments that we will eventually have to implement are NTDs, CDOs, and CDO2.

We all know what a Credit Default Swap (CDS) is, right? It's a form of insurance that someone takes out on a company. One party (the buyer of the insurance) pays a periodic premium to a counterparty (seller of the insurance) for insurance on an underlying instrument (bond or other credit instrument). If there is a "credit event" on the underlying (ie: a company goes bust, misses an interest payment, or the CEO runs away to Bermuda with his secretary), the seller of the insurance must pay the buyer a certain sum of money, known as the "recovery rate". The CDS has some parameters, such as the seniority (who is first in line to get paid in case the company goes belly up), the tenor (how long the buyer has to pay the premiums for), and the notional (the value of the underlying instrument).

There are Indexes on CDS's. We can create our own index, such as the bonds of all of the American auto manufacturers. Or, we can use an exchange-manufactured index.

CDS indices are so popular that there is a CDS index on the Dow. The most widely-traded CDS index is the one for North American Investment Grade instruments. It accounts for over 80% of the CDX volume that is traded.

So, now we know what a CDS Index is. On to Tranches....

A Tranche is a certain level of risk. According to Investopedia:

Tranche is a term often used to describe a specific class of bonds within an offering wherein each tranche offers varying degrees of risk to the investor. For example, a CMO offering a partitioned MBS portfolio might have mortgages (tranches) that have one-year, two- year, five-year and 20-year maturities.

For the above-mentioned index, there are 5 tranches. The Equity tranche covers the first 3% of losses on the credit instruments. The Mezzanine tranche covers from 3-7%. The two Senior tranches cover 7-10% and 10-15% respectively. The Super Senior tranche covers the last 15-30% of losses.

Index Tranches are for active traders. A Bespoken Tranche is one that is put together on the wishes of an investor. It is usually created for long-term investment.

©2005 Marc Adler - All Rights Reserved


David Chapman said...

What is a CDO2 ?

Chris Donnan said...

From : http://www.answers.com/topic/collateralized-debt-obligations

CDOs squared

More complex CDO structured have developed where each underlying credit risk is itself another CDO tranche or Asset Backed Security. These CDOs are typically referred to as CDOs-squared and may contain many references to the same underlying credit risk so are very difficult to price and risk manage.

Typically a CDO squared structure will pay a higher yield for a given rating to reflect the increased complexity and risk.

marc said...

Basically, it's a basket of a basket... or a basket or indexes.

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