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

A trader holds a long equity tranche and a short mezzanine tranche on the same CDO index to hedge. Which description best characterizes the residual correlation exposure of the combined position?

The combined position's correlation sensitivity can have either sign and shifts with spread levels and attachment points, so it is not reliably neutral. Equity is long correlation, but mezzanine sensitivity changes with market conditions, so the hedge needs ongoing recalibration.

  1. AIt is fully correlation neutral because the tranches are on the same portfolio
  2. BThe position is net long correlation from equity only, since mezzanine has no correlation sensitivity
  3. CThe sensitivity to correlation can have either sign and varies with the portfolio spread level and tranche attachment points, so the hedge is not reliably neutralCorrect
  4. DThe position is net short correlation because shorting always dominates

Explanation

Equity is clearly long correlation, while mezzanine sensitivity can be positive or negative depending on spreads and attachment points. Thus the net exposure is unstable and needs monitoring. Same-portfolio does not ensure neutrality, and mezzanine is not insensitive.

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