Structured Credit Index Products and Default Correlation

In mid-2003, Morgan Stanley and JPMorgan launched a number of structured credit products that had exposure to correlations in the credit risks of the firms underlying the TRAC-X index: tranched TRAC-X NA, tranched TRAC-X Europe, and options on both TRAC-X NA and TRAC-X Europe. The values of these TRAC-X derivatives were determined by some key parameters: the probabilities of default of each of the firms covered in the index, the recovery rates of the underlying corporate debt instruments in the event of default, and credit risk correlations among the underlying firms (plus, the value of TRAC-X options was also influenced by the volatility of CDS premiums). Tranched TRAC-X and other tranched products were often quoted in the market at prices that were expressed through an implied correlation parameter. Among the issues facing Morgan Stanley's Lewis O'Donald was the implication of the "implied correlation" quotations on the tranched products. Taken at face value, the quotations available in the market seemed to indicate that different tranches on the same underlying index of firms were trading at different implied default correlations. The market prices of the different tranches implied different default correlations for the same set of underlying firms--meaning that credit protection for the same set of underlying firms could be bought or sold at prices that assumed that the defaults of the underlying firms were correlated differently from the viewpoint of different tranches. This correlation skew across the different TRAC-X tranches represented a form of pricing discrepancy.

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