2 Comments

  1. Cory says:

    I don’t think you can use Correlation to define risk the way you have above. The only risk in your example is default. Since I can’t imagine anyone having a problem with all of the loans in a portfolio paying off. If you instead approached the value of the portfolio from what it is worth on the secondary market you maybe able to show the effects of diversifying in different grades of loans. The risks then would be paying too much for note or of not taking advantage if market mispricing between the different grades of loans. Since these notes are fully amortized in a relatively short period of time it would be very hard to compare older loans to new ones. And also there appears to be an information problem on the secondary market. It is not clear what other people are paying on the secondary market. At least for stock and bond markets you have pricing info that tells you what an asset is selling for so you could mark your assets to market value. Using portfolio theory, if you had the ability to see what other people may be willing to pay for your notes, you would try to make purchases or sales to decrease the correlation of market movements in the value of your portfolio. I suspect that you would find that the difference in trading bands between the grades of notes secondary market are tight.

    1. Justin Hsi Justin Hsi says:

      Hi Cory,

      I’m not sure what you mean by “use correlation to define risk” when we define risk to be the standard deviation in returns. Ideally we would be able to mark everything to market to have our time series of values/returns. Only more time and transactions will give us the data we need.

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