Credit Protection Direction and CDO Tranche Exposure
Summary
The document clarifies how long and short CDO tranche positions relate to credit exposure and credit protection. For cash CDO tranches, an investor buying a tranche takes on credit exposure and receives a spread as compensation. For a synthetic CDO, the issuer may sell credit default swap protection and pass the resulting premiums to tranche investors; economically, those investors are short CDS and long credit exposure.
The answer therefore describes a long tranche as generally representing long credit exposure, equivalent to selling protection, and a short tranche as short credit exposure, equivalent to buying protection. It distinguishes the position in a tranche from the direction of the protection itself, which can make terminology confusing. The explanation is concise and conceptual; it does not address tranche-specific structures, contractual details, or circumstances where a particular CDO’s mechanics could alter the mapping.
Key ideas
- An investor holding a CDO tranche generally takes on credit exposure in exchange for spread income.
- In a synthetic CDO, tranche investors can have exposure equivalent to selling credit protection through CDS.
- A long tranche position is described as long credit exposure and short credit protection.
- A short tranche position is described as short credit exposure and buying credit protection.
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Full text
# CDO selling or buying credit protection? # CDO selling or buying credit protection? I think there is an error in the Meissner text - Correlation Risk Modeling and Management and can't find an errata for this text to verify. On page 19 the foot note reads: > Shorting the equity tranche means being short credit protection or selling credit protection, which means receiving the (high) equity tranche contract spread In the context, he is talking about CDOs, which makes me think this is incorrect. In a CDO, doesn't being short a tranche buy credit protection and investing in the tranche (long) is to sell credit protection? When you invest in one of the tranches of a CDO, you are exposed to credit risk which is why you are compensated by a spread right ? ## Answer by Nicholas (score 1) https://quant.stackexchange.com/a/21755 investor interest in cash cdo tranches is driven by gaining [leveraged] credit exposure; in cash cdo investor goes long credit exposure and statement "going long tranche implies short exposure (i.e. buy credit protection)" is questionable. synthetic: Entity which issues cdo may sell cds and collect premiums; these premiums are further distributed to pay investors in cdo tranches - effectively investors are going short cds (long credit exposure) and collect coupons for doing so. Going long the tranche is effectively long credit exposure (short cds); and going short the tranche is effectively short credit exposure (buy cds). credit protection = short credit exposure short (credit protection) = short (short credit exposure) = long credit exposure hope this helps
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