In the previous chapter, we introduced the synthetic markets, with a ■ focus on credit default swaps and the credit indexes. This chapter takes a closer look at the credit and loan indexes (CDX and LCDX, respectively) and the unique feature of “tranching.”23
This means that the cash flows for the overall index can be divided among holders of different portions of total credit risk, which are referred to as index tranches
The chapter is divided into two parts. In the first part we discuss the basic mechanics of the tranche market. The second part will focus on the LCDX tranche market and the special features of LCDX tranches (such as high recoveries and cancellation events). In addition, we will evaluate whether synthetic tranches are interchangeable with cash tranches and identify some of the similarities and differences.
BASIC MECHANICS OF THE TRANCHE MARKET
The basic building block of an index tranche is a static index portfolio. The most widely traded index tranches are based on the standard credit default swap (i.e., CDS) indexes that we described in the previous chapter: CDX (IG, HY, LCDX) and iTraxx (Main). These indexes are typically equal-weighted static portfolios. CDX.HY and LCDX contain 100 names in their portfolios, while iTraxx Main and CDX.IG contain 125 names.
As we learned in the previous chapter, the indexes provide investors with a tool to efficiently and effectively hedge their corporate bond exposure or to express views on the ...