The Standardized Tranche Market Has Come Out of Hiding

Abstract

Until the end of 2003, customized, single-tranche, synthetic CDOs dominated the credit correlation market. Trading volume was light because of the low liquidity associated with the highly customized tranches. However, a recent consolidation of the credit derivative indices under the Dow Jones banner has resulted in the development of standardized tranches based on these benchmark indices in both North America and Europe. Liquidity of these benchmark indices has grown significantly as more participants enter the market and demand increases. Volumes also have grown exponentially. And the very structure of the market has been transformed, as investors turn not only to the underlying indices, but also to other index-based products such as index options and standardized tranches of the index. In this article, the authors walk through the mechanics of the newly energized standardized tranche market and look at tranche correlation and spread sensitivities.