May 17, 2004

Bear, Stearns & Co. Inc.

383 Madison Avenue
New York, New York 10179
(212) 272-2000
www.bearstearns.com

Structured Product Trading

Martin St. Pierre
44 (20) 7516-6570
mstpierre@bear.com

Emmanuel Rousseau
44 (20) 7516-6570
Valuing and Hedging
erousseau@bear.com

Jeff Zavattero
Synthetic CDO Tranches Using
(212) 272-0422
jzavattero@bear.com Base Correlations
Olivier van Eyseren
44 (20) 7516-6570
ovaneyseren@bear.com The Normal Copula model is the market standard for valuing and hedging
Amit Arora
synthetic CDO tranches. The traditional application of this model links the
(212) 272-0422 protection premium of a tranche with its implied correlation – an
aarora@bear.com unobserved model parameter. Typically, each liquid standard tranche has
its own correlation implied by the market premium. The Normal Copula
Credit Derivatives Analytics
model is also used to calculate a tranche’s delta – the sensitivity to
Dmitry Pugachevsky
(212) 272-2883
changes in the spread of the underlying reference portfolio – as well as to
dpugachevsky@bear.com value non-standard tranches.
Mathieu Fourny Market participants face several challenges when using the Normal
(212) 272-1379
mfourny@bear.com Copula model in the traditional way:

Credit Derivatives Research 1. How to value less liquid, non-standard tranches consistently with
Alex Reyfman standard ones?
(212) 272-1325
areyfman@bear.com 2. How to address the instability and non-uniqueness of junior
mezzanine tranche implied correlations?
This report is the product of
collaboration between credit 3. How to improve the poor historic performance of theoretical
derivatives trading, analytics, and tranche hedges?
research. It presents a new
approach to valuing and hedging A promising approach to addressing these issues is to use base
tranches of synthetic CDOs. Bear correlations. Base correlations are implied correlations corresponding to
Stearns has not acted as advisor to
the recipient of this report with tranches with zero attachment points. This report explains how to:
respect to the desirability or
appropriateness of entering into any 1. Derive base correlations from market-observed standard tranche
transaction described in this report
or with respect to the recipient’s
premiums.
risk management needs generally.
This pertains not only to the
2. Employ base correlations to value non-standard tranches.
financial risk, market risk and
management risks and
3. Calculate tranche deltas using base correlations.
consequences of a transaction, but
also to any legal, regulatory, tax, The report’s technical appendix provides a theoretical analysis of implied
accounting and credit issues tranche and base correlations.
generated by such transactions,
which recipient must evaluate for
itself and in reliance on its own
professional advisors.
 Credit Derivatives

The Tranche Market

The market for synthetic CDO tranches operates like many other derivative markets:

§ Market demand and supply dynamics determine the prices of liquid instruments.
§ A market-standard valuation model is calibrated to match the observed prices.
§ The model is then used to value less liquid instruments and to compute the
sensitivities to changes in the underlying factors.

Currently, in the US, tranches of the Dow Jones CDX.NA.IG index constitute the set of
liquid instruments, while in Europe tranches of the iBoxx Diversified Series 4 CDS index
play the same role. Each tranche is defined by an attachment and an exhaustion point.
Table 1 presents the standard North American and European tranches. The box on the
opposite page describes the mechanics of tranche transactions.

Table 1. Standard CDS Indices and Tranches in the

North American and European Markets
North America Europe
CDX.NA.IG IBX DIV 4C
0-3% 0-3%
3-7% 3-6%
7-10% 6-9%
10-15% 9-12%
15-30% 12-22%
3-100% 3-100%

The attachment and exhaustion points of the standard tranches evolved to create
instruments with distinct risk profiles. For example, the first-loss 0-3% tranche is exposed
to the first several defaults in the reference portfolio, and offers high returns if no defaults
occur. The 3-7% and the 7-10% tranches – the junior and senior mezzanine – are levered
positions in the underlying portfolio spread, but are less immediately exposed to portfolio
defaults. The 10-15% is the senior or triple-A layer, while the 15-30% tranche is the low-
risk “super senior” piece.

Although the tranches presented in Table 1 are the ones quoted by dealers on a daily basis,
tranches with non-standard attachment points also trade frequently. For example, in both
the North American and European markets mezzanine tranches with attachment points in
the 8-10% range are popular.

The prices, or protection premiums, of the standard tranches are determined by market
supply and demand. Most participants use a version of the Normal Copula model –
described in detail below – to compute hedges for the tranches and to value seasoned and
tranches with non-standard attachment and exhaustion points. The model is calibrated to
the observed protection premiums of the standard tranches.

Bear, Stearns & Co. Inc. 3

Credit Derivatives

A Review of Tranche Basics

A standard synthetic CDO (Collateralized Debt Obligation) tranche is a bilateral, over-the-counter credit
derivative contract that transfers a portion of the credit risk of a portfolio from the Protection Buyer to the
Protection Seller. The underlying credit portfolio, called the Reference Portfolio, consists of a large number
(typically, 20 – 200) of credit exposures. Standard synthetic CDO tranches employ one of the benchmark
CDS indices, such as the Dow Jones CDX.NA.IG or the iBoxx Diversified, as the Reference Portfolio.

The figure below illustrates the mechanics of a tranche transaction. The Protection Buyer pays the Seller a
periodic protection premium (or a premium as well as a one-time upfront payment) in return for credit
protection. The premium payments as well as credit protection continue until the transaction matures or until
the notional of the tranche is fully written down by losses. Standard tranches mature on the maturity date of
the underlying index.

The contract specifies a range of credit losses in the portfolio referenced by the tranche. The Protection Seller
begins to make protection payments to the Buyer once credit losses in the underlying portfolio breach the
tranche’s attachment point. Protection payments end and the contract terminates once portfolio losses exceed
the exhaustion point.

Figure 1. Synthetic CDO Tranche Mechanics

Protection
Reference
Seller
Portfolio

Exhaustion Credit Premium ×

Point Protection Tranche
Losses

Notional
Tranche

Attachment
Point Protection
Buyer

Defaults and losses in the Reference Portfolio are determined under the ISDA credit derivatives framework.
In the US, standard tranche Credit Events consist of Bankruptcy and Failure-to-Pay (not Restructuring), while
in Europe and Asia, Restructuring (in the “Modified Modified” variant) is also included. If a name in the
Reference Portfolio suffers a Credit Event, the losses are physically-settled, with the Protection Buyer
delivering obligations of the defaulted name in exchange for par. Recently, fixed recovery contracts, which
are cash-settled, have increased in popularity. Following the protection payment, the notional of the affected
tranches is decreased by the loss amount and subsequent premium payments are made with respect to the
smaller notional.1

After the initial transaction, the tranche can be traded by either unwinding the contract or by assigning it to a
new counterparty. In each case, a payment is made by one of the parties to the other, depending on how the
value of the tranche has changed. Although the standard index tranche market is only about a year old, we
estimate that ten to twenty transactions with a notional of $100 to $200 million equivalent take place daily.

1
See the January 15, 2004 Bear Stearns Credit Derivatives Research report An Introduction to Trading Corporate Credit Default Swaps for
an in-depth explanation of the credit derivative contract terms.

4 Bear, Stearns & Co. Inc.

 Credit Derivatives

The Normal Copula Model and Implied Correlations

The market-standard valuation and hedging methodology for synthetic CDO tranches
employs the Normal Copula model. Figure 2 shows schematically how the Normal Copula
model is used to value tranches. The model takes as inputs:

1. the underlying single-name CDS credit curves in the Reference Portfolio

2. a recovery assumption for each reference name
3. an implied correlation level

The model produces the present value of a synthetic CDO tranche. Since tranches are
swap contracts, by definition, a tranche with a fair-market premium has a present value of
zero.

Figure 2. Using the Normal Copula Model

Single-name CDS Spreads Single -name Survival Probabilities

Survival Probability
Spread (bp)

Time Time

Simulate Default Times Portfolio Loss Probability Distribution

Default Time #2

Probability

Default Time #1 Portfolio Loss

Issuer-level survival probability curves, which give the market-implied probability an

issuer survives to a particular future time, are constructed from the single-name CDS
premium curves using the recovery assumptions. The issuer survival probabilities,
together with the implied correlation parameter, are used to derive a probability loss
distribution for the reference portfolio.2 The Reference Portfolio probability loss
distribution gives the probability of every level of credit losses in the portfolio.

2
The Normal Copula is typically implemented using either Monte Carlo simulation or quasi-analytical methods.

Bear, Stearns & Co. Inc. 5

Credit Derivatives

The correlation parameter plays a key role in determining the shape of the portfolio loss
probability distribution. The higher the correlation parameter value, the fatter are the tails
of the distribution. “Fatter tails” mean that extreme loss outcomes – both very low levels
of defaults and very high levels – are more likely relative to average default levels.
Correspondingly, a low correlation results in a portfolio loss distribution with skinny tails,
meaning that the average loss outcome is more likely relative to extreme default outcomes.

Figure 3 illustrates the sensitivity of the loss probability distribution to changes in the
correlation. Zero correlation produces a bell-shaped loss distribution, with low probability
of either very low or very high losses. As the correlation parameter increases, the
distribution spreads out, increasing the probability of tail events. Although it is not easy to
tell from the figure, the average or expected loss of the portfolio loss distribution is
unaffected by the correlation value.

Figure 3. The Impact of Correlation on the Portfolio Loss Distribution

70
0% Correlation
60 30% Correlation
60% Correlation
50
90% Correlation
Probability (%)

40

30

20

10

0
0 3 6 9 12 15

Percent of Maximum Portfolio Loss

Figure 4 shows the impact of the correlation on the probability of extremely high losses.
For each x-axis value, the figure shows the probability of losses at or above that level.
With 0% correlation, there is essentially no chance of losses exceeding 15%. At the
extreme correlation of 90%, there is a 66% percent probability of zero losses and a 12%
probability of losses greater than 15%.

6 Bear, Stearns & Co. Inc.

 Credit Derivatives

Figure 4. The Impact of Correlation on the Probability of High Portfolio Losses

15
0% Correlation
30% Correlation
12
60% Correlation

Cumulative Probability(%)
90% Correlation
9

0
15 30 45 60 75 90

Percent of Maximum Portfolio Loss

The value of the correlation parameter in the Normal Copula model affects the price of
most tranches. Because higher correlation increases the probability of zero or low credit
losses, the strategy of selling protection on first-loss or very junior mezzanine tranches
benefits from high correlation. The opposite is true for selling protection on senior
tranches – higher correlation increases the probability of high credit losses making senior
tranches more risky. For this reason, selling first-loss and very junior tranche protection is
described as being “long” correlation, while selling senior tranche protection is viewed as
a short correlation position. Note that the value of the entire Reference Portfolio is not
impacted by the correlation parameter.

Most investors appear to use a single correlation value for all of the underlying reference
names when valuing a tranche. Although some market participants have attempted to use
information from equity returns or spread changes to estimate a correlation value for every
pair of names, the market continues to use a single correlation for the entire portfolio
primarily because a clearly compelling alternative has not yet emerged.

For standard tranches with observable market premiums, the Normal Copula model is used
in reverse: Market tranche premiums are transformed into implied correlations. Table 2
shows the bid and offer premiums for the North American and European standard tranches
along with the mid-market implied correlations derived using the Normal Copula model.

The tranche implied correlations are not the same across the capital structure. The implied
correlations of the junior mezzanine tranches are lower than the equity and the senior
mezzanine tranches. This pattern is sometimes called a “correlation smile.” The 3-7%
premium is not very sensitive to implied correlation, so a small change in the fair market
premium of the 3-7% implies a large shift in the correlation. The drastically different 3-7%
tranche correlation relative to both the 0-3% tranche and more senior tranches is viewed
by some market participants as a weakness of the Normal Copula framework. The
technical appendix explains the “correlation smile” by relating it to the correlation
sensitivity of equity tranches.

Bear, Stearns & Co. Inc. 7

Credit Derivatives

A related problem commonly noted about the pattern of market-implied correlations is that
the junior mezzanine tranches – the 3-7% in the US and the 3-6% in Europe – can have
two solutions. For example, in addition to the correlation reported in Table 2 for
CDX.NA.IG 3-7% tranche, 73.20% is also a possible solution. The appendix shows why
multiple implied correlation solutions can occur.

Table 2. North American and European Tranche Bid and Offers and Mid-Market
Tranche Correlations, May 14 2004

Mid-Market
Bid /Offer Implied Mid-Market Implied
NA (Upfront + Running) Correlation (%) Europe Bid /Offer Correlation (%)
0-3% 44.90 / 46.90 + 500 20.5 0-3% 28.25 / 33.25 + 500 19.9
3-7% 400 / 422 1.5 3-6% 235 / 275 7.3
7-10% 152 / 162 17.5 6-9% 95 / 115 18.8
10-15% 59 / 69 21.1 9-12% 50 / 65 24.8
15-30% 13 / 21 29.0 12-22% 18 / 26 30.4
3-100% 26.5 / 32.2 20.9 3-100% 13.5 / 17.5 20.9

Tranche correlations have varied over time. Figure 5 shows the implied correlations for
the CDX.NA.IG 0-3% tranche along with the underlying index level. From January 6 to
May 5, the 0-3% tranche implied correlation generally increased, while the CDX.NA.IG
spread widened. The late January – early February period, characterized by increased
concern about default risk, saw equity correlations drop while spreads widened.

Figure 5. Historical Implied Correlation of the 0-3% Tranche and the CDX.NA.IG
Index Level
23% 70

21% 60
Tranche Correlation

Index (bp)
19% 50

CDX.NA.IG.1 0-3% Corr.

17% CDX.NA.IG.2 0-3% Corr. 40
CDX.NA.IG.1 Index
CDX.NA.IG.2 Index
15% 30
25-Dec 24-Jan 23-Feb 24-Mar 23-Apr
Date

Market participants also use the Normal Copula model to compute the sensitivity of
tranches to changes in the underlying single-name CDS premiums. Tranche sensitivities,
or deltas, are computed by shifting all of the underlying single-name CDS premium curves
up and down by one basis point and averaging the change in the tranche’s theoretical
value. This calculation typically keeps implied correlations unchanged. Table 3 shows the
theoretical deltas for the standard North American and European tranches as of May 14,
2004.

8 Bear, Stearns & Co. Inc.

 Credit Derivatives

Table 3. North American and European Theoretical Tranche Deltas

Tranche Correlation Tranche Correlation

NA Delta Europe Delta
0-3% 11.1 0-3% 16.0
3-7% 17.5 3-6% 12.3
7-10% 5.3 6-9% 4.8
10-15% 2.5 9-12% 2.7
15-30% 0.7 12-22% 1.1

The deltas are expressed as the multiple of the tranche notional that must be transacted in
the underlying index to best hedge the impact of small spread changes. For example, the 0-
3% delta of 11.1 means that an investor who sells protection on the 0-3% tranche and
wishes to hedge the impact of small spread changes must buy 11.1 times the 0-3%
notional in index protection.3

Note that the delta of the 3-7% tranche is higher than the 0-3% delta. This result, found
counterintuitive by many market participants, is caused by three effects:

§ The model assigns a very high loss probability to very junior tranches, which is
not very affected by small changes in spreads.
§ The 0-3% tranche has a large upfront amount that lowers its sensitivity to
spreads.
§ The tranche correlation of the 3-7% tranche is very low, increasing its sensitivity
to spreads.

Base Correlations

Many of the shortcomings of tranche correlations implied by the Normal Copula can be
addressed by using base correlations. Base correlations are defined as the implied
correlations of first-loss tranches – a tranche that starts to suffer losses at the first default
in the reference portfolio of the synthetic CDO. Base correlations allow a natural way to
value tranches with non-standard attachment and exhaustion points. Additionally, deriving
base correlations from market levels never results in two solutions. Finally, as we show
below, hedges computed using base correlations may offer better performance than
traditional hedges.

As with tranche correlations, base correlations are derived from the market premiums of
standard tranches using the Normal Copula model. Base correlations are computed with a
bootstrapping methodology, whereby the base correlation of a junior first-loss tranche is
used in the computation of more senior base correlations.

3
It is important to bear in mind that hedging a tranche with an index contract rather than positions in single-name CDS introduces basis risk.

Bear, Stearns & Co. Inc. 9

Credit Derivatives

Using the CDX.NA.IG standard tranches as an example, we illustrate the base correlation
bootstrapping methodology.4 The 0-3% tranche base correlation is equal to the implied
correlation. To compute the base correlation for the 0-7% first-loss tranche, we use the
following logic:

1. Find the price of the 0-3% tranche with premium equal to the premium of the 3-
7% tranche, using the 0-3% implied correlation (also the 0-3% base correlation)
and the Normal Copula model. Since the 3-7% premium is much lower than the
fair-market 0-3% premium, 0-3% tranche protection with the 3-7% premium will
have a positive price.
2. The 0-7% tranche with the 3-7% fair-market premium can be viewed as a
portfolio of the 0-3% tranche with the 3-7% premium and the 3-7% tranche. Since
the price of the 3-7% tranche with the 3-7% market premium is zero, the price of
the 0-7% tranche with the 3-7% market premium is simply the price of the 0-3%
tranche with the 3-7% premium.
3. Use the Normal Copula model in reverse to extract the 0-7% base correlation
implied by the price of the 0-7% tranche with the 3-7% premium.
4. Next, find the price of the 0-7% tranche with the 7-10% premium using the 0-7%
tranche base correlation
5. Use this price to find the base correlation of the 0-10% tranche.
6. Repeat the procedure until for all liquid tranches.

Table 4 shows the base correlations for the US and European standard tranches as of May
14, 2004.

Table 4. North American and European Tranche Base Correlations*

Mid-Market Mid-Market Mid-Market Mid-Market

Mid-Market Tranche Base Mid-Market Tranche Base
Premium Correlation Correlation Premium Correlation Correlation
NA (bp) (%) (%) Europe (bp) (%) (%)
0-3% 41.95 + 500 20.5 20.5 0-3% 30.75 + 500 19.9 20.1
3-7% 331 1.5 29.0 3-6% 255 7.3 25.8
7-10% 126 17.5 33.1 6-9% 105 18.8 29.2
10-15% 54 21.1 40.8 9-12% 57.5 24.8 31.3
15-30% 16 29.0 63.5 12-22% 22 30.4 33.9
*
The 3-100% tranche can also be valued using base correlations.

Occasionally, the senior-most base correlation cannot be computed from mid-market

tranche premiums. The calculation fails because the present value of the senior-most base
tranche – the 0-30% with the 15-30% premium in the US, for example – is greater than the
value of the entire portfolio with the 15-30% premium. This indicates that, at least
theoretically, an arbitrage opportunity exists. The failure occurs because we often do not
observe the transaction level of the 15-30%, but rely on the indicative mid-market level.

4
Unlike some competing approaches to computing base correlations, we use the values of both the payments-in-default as well as the
premium legs rather than just the present value of the tranche payments-in-default leg.

10 Bear, Stearns & Co. Inc.

 Credit Derivatives

How to Price Non-standard Tranches with Base Correlations

Once we derive the base correlations implied by the standard tranche market, we can use
them to value tranches with non-standard attachment and exhaustion points. For example,
suppose we have found the base correlations for the standard CDX.NA.IG tranches and
wish to value the 6-11% tranche. This non-standard tranche overlaps three standard ones:
the 3-7%, the 7-10%, and the 10-15%.

We find the value of the 6-11% tranche by breaking it up into long and short positions in
first-loss tranches. Selling 6-11% tranche protection is equivalent to selling 0-11% tranche
protection and buying 0-6%. The following algorithm is used to value the 6-11% tranche:5

1. Find the price of the 0-6% tranche by interpolating between the 0-3% and the
0-7% base correlations.
2. Find the price of the 0-11% tranche by interpolating between the 0-7% and the
0-15% base correlations.
3. The price of the 6-11% tranche is difference between the price of the 0-11%
and the 0-6% tranches.
4. We can solve recursively for the 6-11% premium that produces a tranche value
of zero.

How to Compute Deltas Using Base Correlations

The “delta” of a tranche is the approximate change in value caused by a small change in
the underlying index:

DTranche NPV (S , r ) » Delta ´ DI ( S ) ,

where ∆ denotes “change in,” tranche NPV is the net present value of the tranche, S is the
index level, ρ is the correlation parameter, and I is the index value. The traditional method
of computing tranche deltas is to:

1. Shift all of the underlying curves up by 1 bp and calculate the change in the
NPV of the tranche
2. Shift all of the curves down by 1 bp and calculate the change in the NPV
3. Average the results.6

In the process of computing the delta by shifting the curves up and down, the tranche
correlation – the ρ in the above equation – is held constant. However, the underlying curve
shifts implicitly change the base correlations. Figure 6 shows the change in the
CDX.NA.IG base correlation curve when the underlying credit curves are shifted up and
down while tranche correlations are held constant.

5
We use linear interpolation and extrapolation to find the base correlation of tranches with non-standard exhaustion points.
6
Shifting credit curves proportionally to their level rather than by a flat 1 bp may be a better representation of how credit curves actually move
in an index.

Bear, Stearns & Co. Inc. 11

Credit Derivatives

Figure 6. Impact of Credit Curve Shifts on Base Correlations while Tranche

Correlations Are Held Constant
80%

-20% -10% No change

70%
+10% +20%
60%
Spreads tighter
Base Correlation
50%

40%

30%

20% Spreads wider

10%
3% 7% 10% 15% 30%

Tranche Exhaustion Point

An alternative approach to computing deltas is to hold the base correlations constant when
shifting the underlying curves. As an example, consider computing the deltas for the
CDX.NA.IG 7-10% tranche. First, we compute the delta of the 0-7% tranche, holding the
0-7% base correlation constant. Next, the 0-10% tranche delta is computed, also keeping
the base correlation unchanged. The 7-10% delta is simply the difference between the 0-
10% delta and the 0-7% delta.

Of course, keeping the base correlations constant when computing deltas implicitly shifts
the implied correlation of the tranche. Figure 7 shows the shifts in tranche correlations of
the CDX.NA.IG standard tranches when the underlying curves are shifted up and down
and base correlations are held constant. More details on the difference between the two
deltas are given in appendix.

Figure 7. Impact of Credit Curve Shifts on Tranche Correlations while Base

Correlations Are Held Constant
40%

-20% -10% No change

+10% +20%
30%
Tranche Correlation

Spreads tighter

20%

Spreads wider

10%

0%
0%-3% 3%-7% 7%-10% 10%-15% 15%-30%
Tranche

12 Bear, Stearns & Co. Inc.

 Credit Derivatives

Table 4 shows the tranche and base deltas for the standard North American and European
tranches. The tranche and base correlation 0-3% deltas are equal, since the 0-3% tranche
correlation is the same as the 0-3% base correlation. The tranche with the biggest
difference in deltas is the 3-7%, which drops from a 17.5 tranche correlation delta to a 8.2
base correlation delta. The other mezzanine tranches also have lower base correlation
deltas than tranche correlation delta.

Table 4. US and European Theoretical Tranche Deltas

Tranche Base Base Tranche

Correlation Correlation Correlation Correlation
US Delta Delta Europe Delta Delta
0-3% 11.1 11.1 0-3% 16.0 16.0
3-7% 17.5 8.2 3-6% 12.3 8.2
7-10% 5.3 3.6 6-9% 4.8 4.1
10-15% 2.5 2.0 9-12% 2.7 2.3
15-30% 0.7 0.5 12-22% 1.1 1.1

Historical Performance of Tranche Deltas

Since the beginning of the year, implied correlations, both tranche and base, have been
volatile. Tranche delta calculations assume that either the tranche correlation or the base
correlations are constant. Which assumption –constant tranche or base correlations – is
less harmful to the delta performance? Table 5 compares the tracking error performance of
tranche and base correlation deltas over the January 6 – April 27 period.

Table 5. Average Absolute Hedge Tracking Error

CDX.NA.IG Tranches, January 6 – April 27

Tracking Error with Tranche Tracking Error with Base

Tranche Correlation Delta (%) Correlation Delta (%)
0-3% 3.61 3.61
3-7% 2.79 2.51
7-10% 0.99 0.77
10-15% 0.52 0.47
15-30% 0.13 0.11
Through March 30, returns are based on the CDX.NA.IG.1. Since March 30, the returns are based on the
CDX.NA.IG.2.

The tracking error is computed as the absolute value of the difference between weekly
tranche and hedge price returns. The hedge is based either on the tranche correlation delta
or on the base correlation delta. The 0-3% tracking error is the same in both cases, since
the deltas are the same for the two methods. On average, the base correlation delta hedges
of mezzanine tranches have performed slightly better than the tranche correlation deltas. It
is also interesting to note that the tracking errors in Table 4 are quite large for both
hedging methods, especially for the equity and the junior tranches. This is the consequence
of the correlation volatility over this period.

Bear, Stearns & Co. Inc. 13

Credit Derivatives

In Table 6, we show the median ratio of weekly tranche price returns relative to index
price returns over the January 6 – April 27 period. We can interpret this ratio as the
realized historical delta. The table also shows the median tranche correlation and base
correlation deltas for this period.

Table 6. Median Realized, Tranche Correlation, and Base Correlation Deltas

CDX.NA.IG Tranches, January 6 – April 27

Median Tranche Median Base

Tranche Median Realized Delta Correlation Delta Correlation Delta
0-3% 11.92 13.23 13.23
3-7% 9.27 12.89 9.21
7-10% 3.88 4.54 2.12
10-15% 1.87 2.21 1.62
15-30% 0.34 0.62 0.48
Through March 30, returns are based on the CDX.NA.IG.1. Since March 30, the returns are based on the
CDX.NA.IG.2.

Both the tranche and base correlation deltas appear too high for the 0-3% tranche. This
result is surprising. The 0-3% tranche is quite sensitive to index dispersion. When the
index premium widens, dispersion tends to increase as well, generating additional 0-3%
tranche protection returns. This implies that the realized equity delta should be higher than
the theoretical.

The explanation of the low realized 0-3% delta probably lies with implied correlations.
During the period in question, spreads have generally moved wider, while equity
correlations have increased. Rising correlations produced negative equity protection
returns thereby offsetting some of the positive returns caused by spread widening.

Strikingly, at 9.21, the median base correlation delta of the 3-7% tranche is very similar to
the median realized delta of 9.27. By contrast, at 12.89, the tranche correlation 3-7% delta
is much higher. This result offers strong but not conclusive evidence that the base
correlation deltas are superior to tranche correlation deltas.

14 Bear, Stearns & Co. Inc.

 Credit Derivatives

Conclusion

Base correlations are an important methodological advance in the market for synthetic
CDO tranches. Using base correlations, rather than the traditional tranche correlations,
offers several advantages:

§ An easy way to compute the value of tranches with non-standard attachment

and exhaustion points
§ Unique implied correlations for each tranche
§ A better way to compute tranche deltas

Possible drawbacks of using base correlations instead of tranche correlations include:

§ An added layer of complexity

§ Occasional non-existence of a base correlation solution for the 0-30% tranche
in the US and the 0-22% tranche in Europe
§ Relatively high volatility of the 0-30% base correlation in the U.S. and the 0-
22% base correlation in Europe.

Currently, the most important question in the synthetic CDO tranche market, in our view,
is the relationship between changes in implied correlations – whether tranche or base –
and credit spreads. The limited historical evidence points to a negative correlation between
spread moves and changes in base correlations. If this relationship is confirmed, market
participants would be able to improve the performance of tranche hedges by incorporating
the relationship into the calculation of the deltas.

Changes in implied correlations are a source of tranche price volatility that cannot be
hedged with position in the underlying index. For this reason, we emphasize that analysis
of projected tranche performance, including performance of tranches hedged with the
underlying index, should include both spread and correlation scenarios.

The difficulties with the Normal Copula framework described in this report have, in part,
motivated calls from some market participants to abandon or drastically modify the
current approach. For example, some have proposed richer correlation matrices, with
every pair of reference names assigned their own correlation values. Different copula
functions, such as the Student t, have been suggested as well.

Although these refinements may seem intuitively appealing, it is important to bear in mind
the purpose of the Normal Copula model. The Normal Copula framework is intended to be
used primarily as a tranche hedging model, rather than an attempt to describe the world
realistically. In this context, the Normal Copula should be judged primarily on the basis of
tranche hedging errors.

Bear, Stearns & Co. Inc. 15

Credit Derivatives

Technical Appendix

We employ the following notation:

§ V(x, y, r) – value of POND for tranche with attachment points x and y
and correlation r
§ R(x, y) – tranche correlation for tranche (x, y) (based on POND)
§ r(x) – base correlation for exhaustion point x

We will call tranches with a 0% loss attachment point “base tranches.”7

The 3-7% tranche correlation instability: Correlation risk and the tranche
correlation singularity

First, we show that the point of minimum tranche correlation sensitivity (correlation risk)
coincides with a singularity (discontinuity) in tranche correlations.

Using the main identity relating base and tranche correlations:

V(x, y, R(x, y)) = V(0, y, r(y)) – V(0, x, r(x))

and the additive property of POND values:

V(x, y, R(x, y)) = V(0, y, R(x, y)) – V(0, x, R(x, y)),

we get:

V(0, y, r(y)) – V(0, x, r(x)) = V(0, y, R(x, y)) – V(0,x, R(x, y))

Let’s regroup this expression as:

V(0, y, r(y)) – V(0, y, R(x, y)) = V(0, x, r(x)) – V(0, x, R(x, y))

Assuming that base and tranche correlations are similar, and keeping only the first order
terms, we can expand this expression as:

¶V ( 0 , y , r( y )) ¶V ( 0 , x , r( x ))
× ( r( y ) - R( x , y )) » × ( r( x ) - R( x , y ))
¶r ¶r

Denoting correlation derivatives in both sides as Vr¢( y ) and Vr¢( x ) , respectively, we can
express tranche correlation R(x, y) as:

r( y ) × Vr¢( y ) - r( x ) × Vr¢( x )
R( x , y ) » (1)
Vr¢( y ) - Vr¢( x )

7
In the body of the report, we emphasized that the value of both the payment-in-default (POND) as well the premium tranche legs should be
used in bootstrapping base correlations. For the sake of simplicity, in the appendix, we use only the POND values. The results are
qualitatively the same if both the POND and the premium legs are used.

16 Bear, Stearns & Co. Inc.

 Credit Derivatives

Bear in mind that, from the perspective of buying protection, base tranches always have a
negative sensitivity to correlation. Though tranches always have finite size, it is sometimes
useful to look at equation (1) in its infinitesimal form. Assume that the tranche has an
infinitely small size. Then, the limiting formula is:

Vr¢( x )
R( x , x ) = r( x ) + r ¢( x ) (2)
Vrx¢¢ ( x )

i.e. the instantaneous tranche correlation equals to the base correlation plus a term which is
proportional to the sensitivity of the base correlation with respect to the exhaustion point,
proportional to the sensitivity of POND value to change in correlation (correlation risk),
and inversely proportional to change of this sensitivity with respect to the exhaustion
point.

Assume that x* is the point where the POND correlation sensitivity, Vr¢( x ) , reaches its
minimum (i.e. largest in absolute value). At that point, Vrx¢¢ ( x*) = 0 , thus the term in the
denominator of equation (2) equals to 0, implying that the tranche correlation is
discontinuous (exhibits a singularity) exactly at this point.

The figure below plots on the left axis both the base and tranche correlations for POND
values of 1% tranches (from 1% through 30% attachments) and on the right axis the base
tranche correlation sensitivity to parallel shift in correlations of 1%.

The Relationship between Tranche Correlation Sensitivity and

Base and Tranche Correlations
50% 0.0%

-0.5%
40%

Correlation Sensitivity
-1.0%
30%
Correlation

-1.5%
20%
-2.0%
Tranche Correlation
10% Base Correlation
-2.5%
Correlation Risk

0% -3.0%
0 5 10 15 20 25 30

Tranche Attachment (%)

Since we consider base tranches, correlation sensitivity is always negative, and its
minimum is the flipping point i.e. the point where the absolute value of the correlation risk
for 1% tranches starts to decrease. One can see that the flipping point (at 5%) almost
exactly coincides with the tranche correlation singularity (discontinuity) point. It also
follows from (2) that since base correlation is an increasing function, i.e. r ¢( x ) > 0 ,
tranche correlations (of small tranches) lie above base correlations to the left of flipping
point, and below base correlations to the right of the flipping point.

Bear, Stearns & Co. Inc. 17

Credit Derivatives

Multiple implied correlations

Next, we show that for tranches that overlap the flipping (singularity) point, there exists
the possibility of multiple solutions for tranche correlations R(x, y). First, when the entire
tranche is below singularity point x*, i.e. y<x*, then because of Vrx¢¢ < 0 in the interval
(x, y), Vr¢( x ) > Vr¢( y ) , thus

¶V ( 0 , y , r( y )) ¶V ( 0 , x , r( x ))
- <0,
¶r ¶r

which implies:

¶V ( x , y , R( x , y ))
<0 x<y<x*, (3)
¶r

i.e. for tranches below the singularity point, tranche correlation sensitivity is negative, or
in other words, these tranches are short correlation.

Similarly, tranches above the singularity point are long correlation:

¶V ( x , y , R( x , y ))
>0 x*<x<y. (4)
¶r

Finally, tranches that straddle the singularity point, i.e. x<x*<y, can exhibit both positive
and negative sensitivities. These tranches may exhibit multiple tranche correlations.

Base and tranche correlation deltas

Recall that POND values are also functions of the underlying spreads. If we assume that
base correlations are independent of spread levels, then tranche correlations will be
sensitive to spread changes. The expression for the POND value should be rewritten as
V(s, x, y, R(s, x, y)).

Next, we calculate the sensitivity of the POND value to a change in spreads:

dV(s,x,y,R(s,x,y)) ¶V(s,x,y,R(s,x,y)) ¶V(s,x,y,R(s,x,y))

= + × Rs¢ (5)
ds ¶s ¶r

The left hand side of this equation is the full delta (to a parallel spread shift), while the
first term in the right hand side is a partial delta. Note that the full delta assumes that base
correlations are independent of spreads while the partial delta assumes that tranche
correlations are constant.

It can be shown that, if the tranche is either below or above the singularity point, then
Rs¢ <0. Thus, it follows from (3) and (5) that for tranches below the singularity point, base
correlation deltas are greater than tranche correlation deltas. Equations (4) and (5) imply
that for tranches above the singularity point, base correlation deltas are lower than tranche
correlation deltas. For tranches that straddle the singularity, the result is ambiguous, since,
in this case, the last term of equation (5) can be positive or negative.

18 Bear, Stearns & Co. Inc.

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