Diversification Potential of Structured Securities

Abstract

Diversification has been a frequently stated benefit of structured securitizations. In the subprime crisis, however, CDOs (especially ABS CDOs) proved to be concentrations of risk. In this article, the author examines different diversification patterns of structured securities that were deemed beneficial by investors and finds 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, and for mezzanine tranches, the risks may even increase. These results shed new light on the diversification potential of CDOs, which is important in terms of both risk management and valuation.