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Explanation:
The senior (uppermost) tranche of a CDO is only exposed to losses if a large number of the underlying assets default simultaneously. Thus, it is highly sensitive to the default correlation among the underlying assets. A high default correlation implies a greater likelihood of mass defaults, making the senior tranche riskier and the credit protection on it more valuable. Conversely, a marked reduction in default correlation means defaults are more idiosyncratic (independent), significantly lowering the probability of enough defaults occurring to breach the senior tranche's attachment point. Since the financial institution underwrote (sold) the credit protection, a decrease in the likelihood of a payout (activating the protection) means the value of the protection goes down. Therefore, the institution's short position in this credit protection becomes more profitable, leading to a significant increase in the value of their 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.