Explanation:
Underwriting credit protection means the financial institution is short the protection (acting as an insurer) on the senior/uppermost tranche of the CDO. The senior tranche is only affected by losses if a massive wave of defaults occurs across the underlying portfolio. A decrease in default correlation means defaults are less likely to cluster together, making extreme loss scenarios much less probable. Consequently, the probability of the senior tranche suffering losses diminishes. Since the institution has sold protection on this tranche, the reduction in downside risk significantly increases the value of its position.
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Q.29 A financial institution has underwritten credit protection on the uppermost tranche of a Collateralized Debt Obligation (CDO). Assuming all other factors remain constant, how would a marked reduction in the default correlation among the CDO's underlying assets - compared to the correlation assumed during the tranche pricing - affect the firm's position?
A
The impact will be ambiguous and contingent on the specific pricing model and prevailing market conditions.
B
The value of the position will significantly increase, as the likelihood of activating the credit protection diminishes.
C
There will be a notable depreciation in value, as the value of the credit protection itself escalates.
D
The position's value will remain unaffected, since only the expected default losses are relevant, and default correlation does not influence these losses.