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FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

A bank hedges a mezzanine CDO tranche by delta-hedging with index credit default swaps. After a market-wide spread widening, base correlation for the equity tranche falls sharply as a few names deteriorate idiosyncratically. Which risk is the bank most exposed to?

The bank is most exposed to correlation risk and idiosyncratic default risk. A spread-based delta hedge using index CDS does not offset changes in correlation or name-specific jumps, so the mezzanine tranche can lose value despite being hedged.

  1. AInterest rate risk because discount factors change
  2. BCorrelation risk and idiosyncratic default risk that a spread-delta hedge does not captureCorrect
  3. CModel risk eliminated by dynamic hedging
  4. DPure recovery rate risk with no correlation effect

Explanation

A delta hedge against index spreads covers parallel spread moves but not changes in correlation or name-specific jumps. When correlation falls, mezzanine tranche value changes in ways the hedge does not offset, and idiosyncratic defaults create gap risk. Dynamic hedging does not remove model risk.

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