Hey guys, I read in Schweser the following regarding Trade Correlation CDS: “higher defaukt correlation results in lower premium”. Could you plz explain? Thanks, M.
Because the value-added in a first to default basket by the CDS writer is seriously impaired if all five of the names default together. Much better if their correlations are low, as the first to default only provides protection on the first name to default.
The CDS will only cover one default in the basket. If there’s high correlation between the issues in the basket, then when one defaults, others are likely to default, too, yet only one will be covered by the “insurance.”