Diversification Potentials of Structured Securities

Abstract

Diversification has been a frequently stated benefit of structured securitizations. However, in the course of the subprime credit crisis CDOs and especially ABS CDOs turned out to be risk concentrations. In this article, we examine different diversification patterns of structured securities which were deemed beneficial by investors. We find that name diversification is largely ineffective and may even increase the risk of tranches. Similarly, factor or sector diversification in the pool may not have the anticipated effect. Positive effects are only achievable for senior tranches while for mezzanine tranches the risks may even increase. These results shed new light on the diversification potentials of CDOs. They are important in terms of both risk management as well as valuation.