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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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As a financial analyst at a major institution, you are tasked with assessing the implications of changes in market conditions on your institution's financial positions. Your institution has provided default protection for the senior tranche of a Collateralized Debt Obligation (CDO).
Given this scenario, evaluate the impact if there is a significant drop in the default correlation of the assets within the CDO compared to the correlation used during the initial pricing of the CDO tranches, with all other variables remaining unchanged. How does this change in default correlation affect your institution's risk exposure?
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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