wilmott.com

Hi All,Just wondering what you need to do to back out super-senior tranche spreads from observations of the overall index spread and all the other tranche spreads. Is there a simple arbitrage relationship, or do you have to perform the calculation via some form of CDO model?Thanks,Scudly

In theory, if you know all the other tranche spreads, you can solve for the super senior spread that makes creating the CDO breakeven. You don't need a model for that. In practice, super senior spreads are set by market demand and are not sensitive to the spreads in other tranches.

it's a simple calculation. basically the notional and duration weighted sum of all the tranche spreads must equal the index spread. you don't need a model to do this calculation. however, the caveat here is that you need to turn the equity upfront into all spread form which means you need to know the duration of the equity tranche which means you need a model! snake chasing its own tail there. another caveat is that you need the duration on the supersenior tranche to do the calculation above. however to get there you need to know the correlation to get the duration of the tranche. what saves you here is that durations of the senior tranches are all basically the same so it's pretty safe to make that assumption.