Explanation:
The firm has sold protection on the senior tranche. An increase in default correlation means that the underlying assets are more likely to default together. High correlation increases the probability of extreme tail-loss events, meaning the aggregate losses are more likely to reach the attachment point of the senior tranche. Therefore, the probability of the senior tranche suffering losses increases, making the credit protection more valuable. Since the firm has sold this protection (meaning it is short the protection), an increase in the value of the protection represents a significant loss to the firm's position. Thus, B is correct.
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Q.30 An investment firm has sold default protection on the most senior tranche of a collateralized debt obligation. Suppose the default correlation between assets held in the CDO increases sharply, but everything else remains unchanged. How will the firm’s position be affected?
A
It will neither lose nor gain value because correlation does not affect default losses
B
It will lose significant value, since the probability of exercising the protection increases
C
It will either increase or decrease depending on market conditions
D
It will gain significant value because the probability of exercising the protection falls
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