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FRM Part II · FRM Exam Part II · Credit Derivatives

A bank sells protection on a USD 20 million equity tranche (0%-3%) of a synthetic CDO and hedges by buying protection on each name individually using single-name CDS. The hedge ratio is derived from the tranche's delta to each name's spread. After a market-wide spread widening, the equity tranche delta falls while the mezzanine delta rises. What is the best interpretation for the hedger?

A falling equity delta means the equity tranche is now less sensitive to further spread changes, requiring less single-name protection, while the rising mezzanine delta requires larger hedges there. Tranche hedges are dynamic and must be rebalanced as spreads and correlations move.

  1. AThe equity tranche has become less sensitive to spread changes, so less single-name protection is needed against it, while mezzanine hedges need to increaseCorrect
  2. BThe equity tranche has become more sensitive, so the bank must buy more protection against it
  3. CDelta changes do not affect hedging since the tranche is fully hedged at inception
  4. DMezzanine delta rising means mezzanine losses are now impossible

Explanation

Tranche delta is the change in tranche value per change in a name's CDS spread, relative to the single-name CDS. When spreads widen, the equity tranche is already likely to be largely wiped out, so its marginal sensitivity declines, while mezzanine, now closer to taking losses, becomes more sensitive. The hedge must therefore be rebalanced dynamically; it is not static.

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