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Credit derivatives terminology

By Vinod Kothari

   

Correlation skew: If implied correlation is computed from prevailing market prices for different tranches, the common observation is that the implied correlation is higher for the equity tranche, and then keeps coming down for mezzanine tranches, and increases again for the senior tranches. This is mostly for technical reasons for demand/supply, since theoretically, the correlation should be the same for all the tranches. The skewed graph of correlation against different tranches is called correlation skew. The shape of the graph also looks like a smile, hence, may also be referred to as correlation smile.

 

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