Answer: II only

## Explanation Let's analyze each statement: **Statement I: Increasing default correlation decreases senior tranche values but increases equity tranche values** - **Incorrect**: This statement has the relationship backwards. - When default correlation increases, the probability of extreme outcomes increases - either very few defaults (good for equity tranche) or many defaults (bad for senior tranche). - **Equity tranche**: Higher correlation increases the probability of few defaults (good scenario) but also increases the probability of many defaults (bad scenario). However, since equity tranche bears first losses, higher correlation actually decreases equity tranche value because it increases the probability of extreme loss scenarios where the equity tranche is wiped out. - **Senior tranche**: Higher correlation increases the probability of extreme loss scenarios where many defaults occur, which threatens the senior tranche. Therefore, higher correlation decreases senior tranche value. **Statement II: At high default rates, increasing default correlation decreases mezzanine bond prices** - **Correct**: At high default rates, the portfolio is already experiencing significant losses. Increasing correlation in this scenario makes it more likely that the losses will be concentrated and severe enough to impact the mezzanine tranche. Therefore, higher correlation decreases mezzanine bond prices. **Conclusion**: Only Statement II is correct, making option B the correct answer.

Author: LeetQuiz .