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Answer: It will lose significant value, since the protection will gain value.
## Explanation When default correlation decreases sharply for a CDO's most senior tranche: - **The endowment fund sold protection** on the senior tranche, meaning they are effectively long credit risk on that tranche - **Lower correlation** means defaults are more likely to occur independently rather than clustering together - For **senior tranches**, lower correlation **increases** the probability of losses reaching that tranche - When correlation decreases, senior tranches become **riskier** and their protection becomes **more valuable** - Since the endowment fund **sold** protection, they are on the wrong side of this move - the protection they sold becomes more valuable, meaning their position **loses value** **Key Points:** - Senior tranches benefit from high correlation (defaults cluster, protecting senior tranches) - Junior/equity tranches benefit from low correlation (defaults disperse, protecting junior tranches) - The endowment fund's short protection position on senior tranche means they lose when correlation decreases Therefore, the correct answer is **C**: The position will lose significant value, since the protection will gain value.
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An endowment fund has sold default protection on the most senior tranche of a CDO. If the default correlation between assets held in the CDO decreases sharply from the correlation used in pricing the CDO tranches, assuming everything else is unchanged, how will the position of the endowment fund be impacted?
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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