Tim Olson
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description, tags
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| CDO carry strategy that buys a low-quality tranche and delta-hedges by selling a high-quality tranche, earning the spread differential between the two tranches while hedging credit spread exposure. |
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Carry — Tranche Hedging
Section: 11.4 | Asset Class: Structured Assets | Type: Carry / Delta-Hedged
Overview
Rather than using the CDS index as the hedge vehicle, this strategy hedges a long position in a low-quality tranche by selling a high-quality tranche. The hedge ratio is calibrated to equate the risky durations of the two positions, and the trader earns the spread differential between the high-yield low-quality tranche and the low-yield high-quality tranche.
Construction / Mechanics
Position:
- Long a low-quality tranche (e.g., equity 0–3%): receive high spread S_low
- Short a high-quality tranche (e.g., senior): pay lower spread S_high
Hedge ratio: The number of high-quality tranche units to short per unit of low-quality tranche is:
Δ_high = D_low / D_high (488)
where:
- D_low = risky duration of the low-quality tranche
- D_high = risky duration of the high-quality tranche
Economics:
- Net carry = S_low - Δ_high × S_high (per unit time, before defaults)
- Since S_low >> S_high, the trade generates positive net carry when spread-neutral
Return Profile
Profits from the spread differential between the low and high-quality tranches. The delta-hedge neutralises small parallel credit spread moves. Residual exposure includes the correlation between the two tranche spreads, curvature (gamma) as spreads shift, and the risk that defaults breach the low-quality tranche while leaving the high-quality tranche intact.
Key Parameters / Signals
| Parameter | Description |
|---|---|
| Δ_high = D_low / D_high | Hedge ratio: risky durations of low vs. high quality tranches |
| S_low | Spread on low-quality (long) tranche |
| S_high | Spread on high-quality (short) tranche |
| Net carry | S_low - Δ_high × S_high |
| Rehedging | Required as risky durations change with spread moves |
Variations
- Use mezzanine as the hedge instead of senior to change the risk profile.
- Stack multiple tranche pairs (e.g., equity vs. mezzanine and mezzanine vs. senior) in a ladder structure.
Notes
- The correlation between the two tranche spreads is the key residual risk: if the low-quality tranche widens while the high-quality tranche tightens (de-correlation of credit curves), the hedge becomes less effective.
- Unlike the index-hedged strategies (Sections 11.2 and 11.3), there is no single liquid instrument representing the hedge; both legs may have limited secondary market liquidity.
- The hedge ratio Δ_high changes dynamically; frequent rebalancing is required in volatile credit markets.
- This trade is sensitive to the shape of the loss distribution: a bi-modal loss distribution (either very few or very many defaults) affects the two tranches differently.