Tim Olson
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description, tags
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| CDO carry strategy that sells a senior or mezzanine tranche and delta-hedges by buying the CDS index, earning the index spread premium over the tranche cost. |
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Carry — Senior/Mezzanine Tranche with Index Hedging
Section: 11.3 | Asset Class: Structured Assets | Type: Carry / Delta-Hedged
Overview
This is the mirror image of the equity tranche carry trade (Section 11.2). Instead of buying a low-quality tranche and hedging with a short index position, the trader sells a high-quality (senior or mezzanine) tranche and delta-hedges by buying the CDS index. The premiums received from the index exceed the premiums paid on the short senior/mezzanine tranche, generating positive net carry.
Construction / Mechanics
Position:
- Short the senior/mezzanine tranche (protection buyer): pay spread S_senior
- Long the CDS index (protection seller): receive spread S_index
Delta (hedge ratio): Same formula as Eq. (487):
Δ_ix = D / D_ix (487)
where D is the risky duration of the senior/mezzanine tranche and D_ix is the risky duration of the CDS index.
Economics:
- Premium received from the long index position > premium paid on the short senior/mezzanine tranche
- This trade is the opposite of the equity tranche strategy: the index premiums fund the tranche premium cost
Return Profile
Earns positive carry as long as defaults do not trigger payouts on the index position that exceed the spread income. The hedged position is approximately spread-neutral to small parallel credit spread moves. The long index position compensates for portfolio-level default losses; the short senior tranche position profits from non-extreme loss scenarios.
Key Parameters / Signals
| Parameter | Description |
|---|---|
| Δ_ix = D / D_ix | Hedge ratio: senior/mezzanine tranche risky duration / index risky duration |
| S_index | Spread received on long CDS index position |
| S_senior | Spread paid on short senior/mezzanine tranche |
| Net carry | Δ_ix × S_index - S_senior (approximately) |
Variations
- Adjust the quality of the tranche sold (from mezzanine to super-senior) to tune the risk/carry trade-off.
- Use multiple tranches at different quality levels to diversify the credit curve exposure.
Notes
- This strategy is "opposite" to the equity tranche carry trade: the long CDS index position exposes the trader to portfolio-level defaults, while the short senior tranche benefits from low-to-moderate loss scenarios.
- The net carry is typically lower than the equity tranche trade because senior tranche spreads are lower.
- Correlation risk applies here as well: if correlation decreases (idiosyncratic defaults increase), the index position is hit harder than a diversified senior tranche.
- The CDS index is a liquid instrument; basis risk between the index and individual tranche spreads is a key residual risk.