Fitch Ratings is introducing a new method for investors to assess correlation levels as part of their risk management processes for collateralized debt obligation investments. The correlation theory takes 2,500 companies that are contained in CDOs, groups them into sectors and analyzes their equity prices to determine default probabilities on a sector-wide basis, according to Richard Hrvatin, managing director and head of credit risk modeling. The correlation method is different from past methods Fitch has used because this one is consistent with its new VECTOR methodology for rating CDOs, he adds.
Hrvatin says it is important for CDO investors to understand just how correlated their assets are to each other because holders of senior classes use the bonds to make a diversified bet on the market while first-loss holders have different motives. "A low correlation means you're spreading your chips across the table and you don't want that," he explains, referring to equity-tranche investors. And, investors who take on a portfolio of CDOs need to measure just how correlated they are, and not only base investments on maturity and ratings, according to Fitch.