Why is there an inverse relationship between weighted average rating factor and weighted avg spread?
WAS = weighted average spread WARF = weighted average rating factor 1. WAS is increased by assuming more credit risk… the more credit risk you assume, the lower your rating is and therefore WARF is reduced. On the other hand… 2. WAS is decreased by assuming less credit risk… the less credit risk you assume, the higher your rating is and therefore WARF is increased. -------------------------------------------------------------------------------- As an extension of the inverse relationship discussion…the WAS and WARF have conflicting goals that manifest themselves in the ordered tranches of the CDO structure in the following way: 1. in the more senior tranches, yields are more dependent on the higher credit quality of the collateral…you want the WARF to be maximized here 2. in the less senior tranches (equity), yields are more dependent instead on the higher spread income…you want to the WAS to be maximized here 3. in the mezzanine (middle) tranches…yields are dependent on both the credit quality and the spread…you want the best balance between the WARF and the WAS here Hope that helps!
Oops… - replace: “more” senior tranches by “most” senior tranche - replace: “less” senior tranches by “least” senior tranche (to be correct since I used the terms “maximized” and “minimized,” respectively)
thanks!
Wasn’t there a character called Warf on Star Trek?