Tim Olson
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description, tags
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| CDO curve flattener/steepener strategy that takes simultaneous long and short positions in CDO tranches of different maturities, betting on changes in the shape of the CDO spread curve. |
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CDO Curve Trades
Section: 11.6 | Asset Class: Structured Assets | Type: Relative Value / Curve
Overview
Analogous to curve trades in bonds (Section 5.13), CDO curve trades involve simultaneous long and short positions in CDO tranches of different maturities. A flattener (steepener) bets that the spread curve will flatten (steepen), meaning the differential between long-term and short-term tranche spreads will decrease (increase). The trade can be structured to be dollar-neutral, risky-duration-neutral, or carry-neutral.
Construction / Mechanics
Flattener: Sell (buy protection on) a short-term tranche + Buy (sell protection on) a long-term tranche.
- Profits if long-term spreads fall relative to short-term spreads (curve flattening).
- In a flattener with S_long > S_short: the trade has positive carry.
Steepener: Buy (sell protection on) a short-term tranche + Sell (buy protection on) a long-term tranche.
- Profits if long-term spreads rise relative to short-term spreads (curve steepening).
Carry over period [t, t+Δt]:
C(t, t+Δt) = (M_long × S_long - M_short × S_short) × Δt (490)
where M_long, M_short are the long and short tranche notionals, and S_long, S_short are their spreads.
P&L: The MTM P&L of the strategy is:
P&L = M_long - M_short (491)
where M_long and M_short are the long and short tranche MTM values (Eq. 485 from Section 11.1).
Structuring options:
- Dollar-neutral: M_long = M_short (equal notionals)
- Risky-duration-neutral: D_long = D_short (Eq. 486); equal risky duration exposure
- Carry-neutral: M_long × S_long = M_short × S_short (zero net carry at inception)
Return Profile
Profits from the anticipated change in the shape of the CDO spread curve (flattening or steepening). The trade eliminates much of the outright credit spread level exposure when structured as duration-neutral. For an upward-sloping curve (S_long > S_short), a flattener has positive carry (favourable in stable conditions).
Key Parameters / Signals
| Parameter | Description |
|---|---|
| S_long, S_short | Spreads on long and short maturity tranches |
| M_long, M_short | Tranche notionals |
| C(t, t+Δt) | Carry over the holding period (Eq. 490) |
| Structuring method | Dollar-neutral / duration-neutral / carry-neutral |
| P&L = M_long - M_short | Mark-to-market gain/loss (Eq. 491) |
Variations
- Index curve trade: implement with CDS index tranches of different tenors (e.g., 5-year vs. 10-year CDX).
- Cross-tranche curve trade: combine different tranche quality (e.g., equity 5yr vs. senior 10yr) for a combined curve and quality bet.
Notes
- Upward-sloping CDO spread curves give positive carry on flattener trades (sell short-term protection, buy long-term protection when S_long > S_short).
- Duration-neutral structuring ensures that small parallel shifts in the spread curve do not generate P&L; the trade is a pure curve bet.
- The risky duration changes as spreads move, requiring periodic rebalancing to maintain duration neutrality.
- Liquidity at the long end of the CDO curve is typically lower than at the standard 5-year tenor; transaction costs may be significant.