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Answer: It will gain significant value, since the probability of exercising the protection falls.
The correct answer is B. When a financial firm sells default protection on the most senior tranche of a CDO (Collateralized Debt Obligation), it is essentially taking on the risk of defaults within the CDO. If the default correlation between assets held in the CDO decreases sharply from the level used in pricing the CDO tranches, the probability that a large number of defaults will occur simultaneously also decreases. This is because high correlation implies that defaults are likely to be clustered, while low correlation suggests that defaults are more independent events. As a result, the risk of the senior tranche experiencing losses due to defaults is reduced. Consequently, the value of the protection sold by the financial firm increases, as it becomes less likely that the protection will need to be exercised. This means the firm will gain significant value from its position.
Author: LeetQuiz Editorial Team
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A financial company has provided protection against defaults for the senior tranche of a Collateralized Debt Obligation (CDO). Originally, the correlation of defaults among the underlying assets in the CDO was higher and used to price the different tranches of the CDO. Now, if the correlation of defaults among these assets significantly decreases while all other parameters remain unchanged, how will this change impact the financial firm's position?
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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