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FRM Part II · FRM Exam Part II · Structured Credit Risk

A desk quotes base correlations for a standard credit index. The 0-3% equity tranche has a base correlation of 25% and the 0-7% tranche has a base correlation of 40%. What is the main reason practitioners use base correlation rather than a single compound correlation for each tranche?

Base correlation is preferred because compound correlation for mezzanine tranches may have multiple solutions or none, since mezzanine value is not monotonic in correlation. Base correlation decomposes tranches into equity-style 0-K pieces whose value moves monotonically with correlation, giving a unique implied value, though it still relies on a copula.

  1. ACompound correlation can be non-unique or fail to exist for mezzanine tranches, whereas base correlation is built from equity-type tranches and is generally monotonic in valueCorrect
  2. BBase correlation removes the need for a copula model when pricing tranches
  3. CBase correlation guarantees that all tranches are priced at their par spreads without calibration
  4. DBase correlation is equal to the average pairwise equity return correlation of index constituents

Explanation

Mezzanine tranche value is not monotonic in correlation, so a compound correlation may have two solutions or none. Base correlation prices each tranche as the difference of equity tranches 0-K, whose value is monotonic in correlation, giving a unique solution. It still uses a copula and requires calibration.

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