Advanced Methods of Risk Management

Lecture 6
Basket credit derivatives and securitisation
Learning objectives
• First-to-default and last-to-default
• Securitisation: markets and products
• Securitisation hedging
• Correlation trading
• Large CDO (ABS)
Probability relationships

• Assume two obligors, and denote

PI, I = A, B the probabilities of default
FI = 1 – PI , I = A, B survival probabilities
PA  B = Probability of default of A and B
FA  B = 1 – (PA + PB) + PA  B
= FA + FB – 1 + PA  B
= Survival probability of A and B
FA – FA  B = Probability of survival of A and default of B
FB – FA  B = Probability of survival of B and default of A
PA – PA  B = Probability of default of A and survival of B
PB – PA  B = Probability of default of B and survival of A
Probability (OR)

• Default probability of B or A
PAB=1 – FAB = PA + PB – PAB
where we have used
FAB = 1 – (PA + PB) + PAB
• Survival probability of B or A
FAB=1 – PAB = FA + FB – FAB
First-to-default
• Consider a credit derivative written on a basket of n
obligors, that is a contract providing “protection” the
first time that an element in the basket of obligsations
defaults. Assume the protection is extended up to time
T.
• The value of the derivative is
FTD = LGD v(t,T)(1 – P0)
• P(0) is the survival probability of all the names in the
basket:
P0 P(1 > T, 2 > T…, n > T)
Last-to-default
• Consider a credit derivative providing “protection”
only the last time that an element in the basket of
obligsations defaults. Assume the protection is
extended up to time T.
• The value of the derivative is
n-TD = LGD v(t,T)Pn
• Pn denotes default of all the names in the basket:
Pn P(1 ≤ T, 2 ≤ T…, n ≤ T)
A bivariate example
• Consider n = 2, default probabilites PA, PB, survival
probabilities FA, FB.
FTD = 1 – FAB = PA + PB – PAB

2-TD = PAB
• Notice
FTD + 2-TD = PA + PB
• The expected loss on the whole portfolio is the sum of
the expected losses of any single obligor and does NOT
depend on the correlation among defaults.
 Modigliani-Miller (credit portfolios)
• Assume a credit portfolio of n obligors.
• The expected loss of the portfolio does not depend on the dependence structure of the
defaults.
• Assume two credit derivatives:
• First x-to-default
• Last (n-x)-to default
• The two products are exposed to two risk factors
• Increase in the expected losses in the portfolio
• Increase in the dependence of defaults in the portfolio
• The increase in expected losses increases the expected loss of both the credit derivative
products
• The increase in the dependence of defaults increases the expected loss of the last (n-x)-to-
default and decrases the expected loss of the first x-to-default product, so that the sum of
the two is unchanged (banana effect).
First-to-default CDS

• Denote FTDm the CDS spreads for the first-to-default

protection of a set of n obligors.

 P t   P t vt , t 
0 i 1 0 i i
FTDm  LGD i 1
m

 vt , t P t 
i 1
i 0 i 1
Px probability specification
• Evaluating basket credit derivatives and the credit
risk of a portfolio requires to specify the joint
distribution of defaults Px
• This distribution depends on two elements
• Default probability of each obligation in the basket.
• The correlation (dependence) structure of defaults of
the obligations in the portfolio.
Models for Px
• The hypotheses that can be made about expected loss of
individual obligations are
• Homogeneous pool of exposures (same default probability)
• Heterogeneous pool of exposures (different default
probabilities)
• Hypotheses about dependence structure are
• Indipendent defaults
• Multivariate reduced form models (Marshall Olkin)
• Copula functions
• Factor copulas (conditionally indipendent defaults)
Securitization deals

Senior Tranche
Originator
Junior 1 Tranche
Special
Sale of Purpose
Vehicle
Assets Junior 2 Tranche
SPV

… Tranche

Equity Tranche
 The economic rationale

• Arbitrage (no more available): by partitioning the basket of

exposures in a set of tranches the originator used to increase the
overall value.
• Regulatory Arbitrage: free capital from low-risk/low-return to
high return/high risk investments.
• Funding: diversification with respect to deposits
• Balance sheet cleaning: writing down non performing loans and
other assets from the balance sheet.
• Providing diversification: allowing mutual funds to diversify
investment
 Structuring securitization deals

• Securitization deal structures are based on

three decisions
• Choice of assets (well diversified)
• Choice of number and structure of tranches
(tranching)
• Definition of the rules by which losses on assets
are translated into losses for each tranches
(waterfall scheme)
Choice of assets

• The choice of the pool of assets to be securitized

determines the overall scenarios of losses.
• Actually, a CDO tranche is a set of derivatives written on an
underlying asset which is the overall loss on a portfolio
L = L1 + L2 +…Ln
• Obviously the choice of the kinds of assets, and their
dependence structure, would have a deep impact on the
probability distribution of losses.
Tranche

• A tranche is a bond issued by a SPV, absorbing

losses higher than a level La (attachment) and
exausting principal when losses reach level Lb
(detachment).
• The nominal value of a tranche (size) is the
difference between Lb and La .
Size = Lb – La
Kinds of tranches

• Equity tranche is defined as La = 0. Its value is a put

option on tranches.
v(t,T)EQ[max(Lb – L,0)]
• A senior tranche with attachment La absorbs losses
beyond La up to the value of the entire pool, 100.
Its value is then

v(t,T)(100 – La) – v(t,T)EQ[max(L – La,0)]

Arbitrage relationships

• If tranches are traded and quoted in a liquid market, the following

no-arbitrage relationships must hold.
• Every intermediate tranche must be worth as the difference of
two equity tranches
EL(La, Lb) = EL(0, Lb) – EL(0,La)
• Buyng an equity tranche with detachment La and buyng the
corresponding senior tranche (attachment La) amounts to buy
exposure to the overall pool of losses.
v(t,T)EQ[max(La – L,0)] +
v(t,T)(100 – La) – v(t,T)EQ[max(L – La,0)] =
v(t,T)[100 – EQ (L)]
Securitisation example
• Consider the assets to be securitized to be two loans with default
probabilities and , and nominal value . Denote the joint default
probability and the corresponding survival copula with
• Scenarios:
0 defaults, loss 0, probability .
1 default, loss 60, probability
2 defaults, loss 120, probability
 Securitisation example: continued
• Assume a securitization of both the loans with funding given by equity (E,
detachment 10%), mezzanine (M, detachment 40%) and senior, S.
• Equity: size = 20,

• Price:
• Mezzanine: size = 80 – 20 = 60
•

• Price
• Senior: size = 200 – 80 =120,
•
• Price =
Modigliani-Miller for tranches
• The value of the assets in the securitisation deal is invariant to
tranching.
• In our example: Buy 20 Equity, 60 Mezzanine and 120 Senior
• From the previous calculations:
•

It is immediate to check that

Delta hedging
• Assume you want to hedge the equity tranche by an opposite position in the overall
portfolio. Remember that the size of the portfolio, that we denote Z, is 200, while the
size of equity is 20.
• A sensitivity of the portfolio expected loss to a small change of the default probability of
the two obligors is

• Now, the sensitivity of the equity tranche expected loss to the same shock is

• Writing everything in terms of the portfolio expected loss, we have that

Delta-mezz hedging
• Notice that in our example, the expected loss of the mezzanine can be
written as

• We can then compute the delta of the mezzanine as

From which we can retrieve the delta of the equity with respect to the
mezzanine as
Exposure to correlation
• Notice that the invariance result above implies that different tranches,
in particular the extreme ones have opposite sensitivities to correlation.
• The equity tranche is long correlation, because an increase in
correlation reduces the expected loss
• The senior tranche is short correlation, because an increase in
correlation increases the expected loss.
• The sign of the mezzaning and other indermediate tranches is not
determined in principle, since it depends on several factors, an in
particular on relative size of the loss and the size of the tranche
• Hint: try to modify the example, assuming .
Correlation scenarios
• Assume and two extreme dependence scenarios
• Independence:
• Equity =
• Mezzanine =
• Senior =

• Perfect dependence:
• Equity =
• Mezzanine =
• Senior =
 Tranches and correlation
1,02

0,98

0,96

0,94

0,92

Equity
Mezz
0,9
Senior
Portfolio

0,88

0,86
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1
 % Sensitivity of the tranches to changes in 1 bp of DPs
0,0000000%
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1

-0,0050000%

-0,0100000%

-0,0150000%

-0,0200000%

-0,0250000%

Equity Mezz Senior Index

Risk of different “tranches”

• Different “tranches” have different risk features.

“Equity” tranches are more sensitive to
idiosincratic risk, while “senior” tranches are
more sensitive to systematic risk factors.
• “Equity” tranches used to be held by the
“originator” both because it was difficult to place
it in the market and to signal a good credit
standing of the pool. In the recent past, this job
has been done by private equity and hedge funds.
Securitization zoology

• Cash CDO vs Synthetic CDO: pools of CDS on the asset side, issuance of
bonds on the liability side
• Funded CDO vs unfunded CDO: CDS both on the asset and the liability
side of the SPV
• Bespoke CDO vs standard CDO: CDO on a customized pool of assets or
exchange traded CDO on standardized terms
• CDO2: securitization of pools of assets including tranches
• Large CDO (ABS): very large pools of exposures, arising from leasing or
mortgage deals (CMO)
• Managed vs unmanaged CDO: the asset of the SPV is held with an
asset manager who can substitute some of the assets in the pool.
Synthetic CDOs
Senior Tranche
Originator
Junior 1 Tranche
Protection Special
Sale Purpose
Vehicle
CDS Premia Junior 2 Tranche
SPV
Interest
Investment
Payments … Tranche
Collateral
AAA
Equity Tranche
CDO2
Originator
Senior Tranche
Tranche 1,j
Junior 1 Tranche
Tranche 2,j Special
Purpose
Vehicle
Junior 2 Tranche
Tranche i,j SPV

Tranche … … Tranche

Equity Tranche
Standardized CDOs

• Since June 2003 standardized securitization deals were introduced in

the market. They are unfunded CDOs referred to standard set of
“names”, considered representative of particular markets.
• The terms of thess contracts are also standardized, which makes them
particularly liquid. They are used both to hedged bespoke contracts
and to acquire exposure to credit.
• 125 American names (CDX) o European, Asian or Australian
(iTraxx), pool changed every 6 months
• Standardized maturities (5, 7 e 10 anni)
• Standardized detachment
• Standardized notional (250 millions)
 i-Traxx and CDX quotes, 5 year, September 27th 2005

i-Traxx CDX

Tranche Bid Ask Tranche Bid Ask

0-3% 23.5* 24.5* 0-3% 44.5* 45*

3-6% 71 73 3-7% 113 117

6-9% 19 22 7-10% 25 30

9-12% 8.5 10.5 10-15% 13 16

12-22% 4.5 5.5 15-30% 4.5 5.5

(*) Amount to be paid “up-front” plus 500 bp on a running basis

Source: Lehman Brothers, Correlation Monitor, September 28th 2005.
Gaussian copula and
implied correlation

• The standard technique used in the market is based on Gaussian copula

C(u1, u2,…, un) = Nn (N – 1 (u1 ), N – 1 (u2 ), …, N – 1 (un ); )
where ui is the probability of event i  T and i is the default time of the i-th
name.
• The correlation used is the same across all the correlation matrix.The value of a
tranche can either be quoted in terms of credit spread or in term of the
correlation figure corresponding to such spread. This concept is known as
implied correlation.
• Notice that the Gaussian copula plays the same role as the Black and Scholes
formula in option prices. Since equity tranches are options, the concept of
implied correlation is only well defined for them. In this case, it is called base
correlation. The market also use the term compound correlation for
intermediate tranches, even though it does not have mathematical meaning
(the function linking the price of the intermediate tranche to correlation is NOT
invertible!!!)
Base correlation
 Correlation 0% Default Probability

Correlation 20%

Correlation 95%

MC simulation pn a basket of 100 names

Tranche hedging: May 2005
• Tranches can be hedged, by:
• Taking offsetting positions in the underlying CDS
• Taking offsetting positions in other tranches (i.e. mezz-
equity hedge)
• These hedging strategies may fail if correlation
changes. This happened in May 2005 when
correlation dropped to a historical low by causing
equity and mezz to move in opposite directions.
Example of iTraxx quote
Large CDO

• Large CDO refer to securitization structures which

are done on a large set of securities, which are
mainly mortgages or retail credit.
• The subprime CDOs that originated the crisis in
2007 are examples of this kind of product.
• For these products it is not possible to model each
and every obligor and to link them by a copula
function. What can be done is instead to
approximate the portfolio by assuming it to be
homogeneous .
Gaussian factor model (Basel II)
• Assume a model in which there is a single factor driving all losses.
The dependence structure is gaussian. In terms of conditional
probabilility

 N 1 u   m 
Pr Default M  m   N  
 1   2 
 
where M is the common factor and m is a particular scenario of it.
Conditional independence
• Once we condition on the one factor model we can assume that the
conditional probabilities are independent
• Then, we can compute the losses conditional on each scenario, use
the product copula to compute the joint probability of default, and
then, integrate over the scenarios:
Vasicek model
• Vasicek proposed a model in which a large number of obligors has
similar probability of default and same gaussian dependence with the
common factor M (homogeneous portfolio.
• Probability of a percentage of losses Ld:

 1   2 N 1 L   N 1  p  
Pr L  Ld   N  d 
  2

 
 Vasicek density function
16

14

12

10

Rho = 0.2
8 Rho = 0.6
Rho = 0.8

0
0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9 1
Tranches in Vasicek model
• The mean value of the distribution is p, the value of default
probability of each individual
• Value of the senior tranche with attachment equal to Ld is
Senior(Ld) = (p – N2 (N-1(p); N-1 (Ld);sqr(1 – 2))
where N(N-1(u); N-1 (v); 2) is the gaussian copula.