Choate’s final comments to Hale detail how he also looks for structured financial instruments that offer diversification benefits and attractive expected returns. These are listed in Exhibit 1, which shows recent COF portfolio positioning relative to the benchmark and reflects various opportunities Choate has uncovered across several markets.
Exhibit 1
COF Portfolio Holdings as of 12/31/xx
Portfolio (%)
Benchmark (%)
Investment-Grade Credit
82
100
Emerging Market Credit
5
0
High Yield
3
0
Collateralized Debt Obligations
Senior Tranche (Class A)
–10
0
Subordinated Tranche (Class B)
10
0
Mortgage-Backed Securities
10
0
Total
100
100
Based on Choate’s final comments and the COF portfolio positions in Exhibit 1, Choate is most likely expecting:
improved real estate markets and higher interest rate volatility.
lower interest rate volatility and increasing default correlations.
lower interest rate volatility and decreasing default correlations.
Answer is B. Why is it B? With increasing correlations if defaults happen in IG then they happen in mezzanine too. If defaults are increasing across the board why would I buy mezzanine? Not following the logic here.
B is correct. Choate expresses his belief that market expectations of interest rate volatility will decrease, so he buys agency MBS in the COF portfolio. The correlation of expected defaults on the collateral of a CDO affects the relative value between the senior and subordinated tranches; as default correlations increase, the value of mezzanine tranches usually increases relative to the value of senior tranches. Because he expects the correlation to be highly positive, he can try to profit by selling the lower yielding (or selling short) Class A and buying the higher yielding Class B.
I guess then this is assuming that defaults are going down in order to profit from this kind of a strategy. I always sort of assumed that its beneficial to ahve correlations decrease. I can’t remember why. from frm I think it had something to do with managing duration.
I have the same question about the default correlation. If the default correlations are going to increase, why are we even taking a position in these bonds?
So if both are going to default later, why do we even care about holding the bonds, especially the subordinated one if we know they will default sometime later on and we wont get any payments from it
ah ok so it’s more like an assumption that yes the default correlations increase, but it’s not written anywhere that they will default. So in case things turn out better than expected then in that case if we did take some positions, we would benefit