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

A desk holds a long position in a mezzanine CDO tranche and is hedged with a short position in the equity tranche of the same CDO, sized so the position is delta-neutral to spread changes. Which risk is the position most exposed to, if the base correlation for the mezzanine attachment range falls sharply while spreads stay unchanged?

The position retains correlation risk. Delta-neutrality hedges small spread moves only, while equity and mezzanine tranches have different correlation sensitivities. A sharp fall in base correlation therefore produces a profit or loss even with unchanged spreads, so the claim of no exposure is wrong.

  1. AOnly interest rate risk, since spreads are unchanged
  2. BA loss or gain driven by correlation, because the mezzanine and equity tranches respond to correlation changes with different signs and magnitudesCorrect
  3. CNo exposure, because delta neutrality removes all correlation sensitivity
  4. DPure recovery rate risk, since correlation does not affect tranche pricing

Explanation

Delta-neutrality hedges only first-order spread moves. Equity tranches generally lose value as correlation falls, while mezzanine tranches can have ambiguous or opposite sensitivity. The combined position keeps a residual correlation exposure. Claiming no exposure is wrong because delta neutrality does not cover correlation sensitivity.

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