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Answer: It will gain significant value, since the probability of exercising the protection falls.
The correct answer is B. The senior tranche will gain value if the default correlation decreases. High correlation implies that if one name defaults, a large number of other names in the CDO will also default. Low correlation implies that if one name defaults, there would be little impact on the default probability of the other names. Therefore, as the correlation decreases, the cumulative probability of enough defaults occurring to exceed the credit enhancement on the senior tranche will also decrease. Hence the investor who has sold protection on the senior tranche will see a gain.
Author: LeetQuiz Editorial Team
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In the context of a financial firm that has sold default protection on the most senior tranche of a Collateralized Debt Obligation (CDO), what would be the impact on the firm's position if there is a substantial decrease in the default correlation between the underlying assets of the CDO, while keeping all other variables unchanged?
A
It will either increase or decrease, depending on the pricing model used and the market conditions.
B
It will gain significant value, since the probability of exercising the protection falls.
C
It will lose significant value, since the protection will gain value.
D
It will neither gain nor lose value, since only expected default losses matter and correlation does not affect expected default losses
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