Can CDO Equity Be Short on Correlation?

Abstract

Collateralized debt obligations (CDO) became very popular investment vehicles in recent years—until the financial crisis started unfolding in summer 2007. As evidenced by the recent crisis, there was a failure by market participants to understand the complex relationships between various risk drivers, such as correlations and their impact on the credit worthiness of different tranches across a CDO capital structure. As a step in the direction of understanding these risks, this article examines the impact of correlation on the value of a CDO equity tranche. By examining the impact of an increase in correlation among underlying assets on the value of a collateralized debt obligation (CDO) equity tranche, the authors show that, contrary to general perception, CDO equity can be short on correlation. Specifically, when the underlying reference portfolio comprises high quality assets (assets with low probability of default) or diverse assets (assets with low correlations), the upfront price of a CDO equity tranche can increase with correlation. The implication of these findings is that not all senior and equity tranche trade combinations provide effective correlation hedging. In fact, in some cases, this type of “hedge” might actually increase the correlation risk.