Explanation:
A decrease in default correlation implies that defaults become more independent. This increases the probability that a few defaults will occur (hurting the first-loss equity tranche) but decreases the likelihood that a large cluster of defaults will occur simultaneously (benefiting the senior tranche). An increase in default probability hurts both, but the structural effect of lower correlation primarily shifts risk down the capital structure to the equity tranche and away from the senior tranche. Therefore, the equity tranche becomes riskier (its value drops), and the senior tranche becomes safer (its value rises). The analyst would recommend purchasing the senior tranche and selling the equity tranche.
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Q.34 An investment firm is contemplating taking positions in various tranches of a collateralized debt obligation. The chief CDO analyst at the firm predicts that the default probability will increase significantly and that default correlation will decrease. On this basis, the analyst will most likely recommend the:
A
Purchase of the senior tranche and sale of the equity tranche
B
Purchase of the equity tranche and sale of the senior tranche
C
Purchase of the senior tranche and purchase of the equity tranche
D
Sale of the senior tranche and sale of the equity tranche
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