Abstract
The purpose of this chapter is to explain (default) correlation trading to elaborate on the dependence of tranche prices and basket default swaps on default correlation. We first use a simple example with three assets to show how increases in default correlation increase spreads of senior tranches but decrease spreads of equity tranches. We relate this insight to recent movements in tranche spreads. We then introduce the standard market (Gaussian copula) model and apply it. We highlight similarities between compound correlations implied by this model and implied volatility from the Black–Scholes model. Compound correlations are shown to differ from base correlations. Finally, we discuss how views about default correlation can be expressed by means of long and short tranche positions. An investor can trade correlation by delta hedging against movements in the underlyings. Finally we discuss how such positions can be hedged and risk managed and what the different profit sources of such strategies are.
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