Explanation:
The firm has sold default protection on the most senior tranche of a CDO. An increase in default correlation implies that the underlying assets are more likely to default together. This heightened tail risk significantly increases the probability that the default losses will breach the attachment point of the senior tranche. As the likelihood of the protection being triggered increases, the value of the protection contract goes up, which implies a loss in value for the protection seller (whose liability has increased).
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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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