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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 selling a form of insurance against defaults within the CDO. The value of this protection is influenced by the default correlation between the assets within the CDO. If the default correlation decreases sharply from what was used in pricing the CDO tranches, it implies that the likelihood of multiple defaults occurring simultaneously is reduced. High correlation means that defaults are more likely to be clustered, increasing the risk for the senior tranche, as it is the first to absorb losses in the event of defaults. Conversely, low correlation suggests that defaults are less likely to be clustered, which reduces the risk for the senior tranche. As a result, the probability of enough defaults occurring to breach the credit enhancement level on the senior tranche decreases when default correlation falls. Therefore, the financial firm that has sold the protection will see an increase in the value of its position because the risk it has insured against (i.e., the risk of defaults in the CDO) has diminished. This means that the firm is less likely to have to pay out on the protection it has sold, which increases the value of its position. The explanation is based on the principles outlined in Allan Malz's "Financial Risk Management: Models, History, and Institutions," specifically Chapter 9 on Structured Credit Risk.
Author: LeetQuiz Editorial Team
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A financial institution has provided default coverage for the highest tranche of a Collateralized Debt Obligation (CDO). Consider a scenario where the correlation of defaults among the assets within the CDO significantly decreases from the original correlation level used when pricing the CDO tranches, while all other variables 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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