The correct answer is C.

Systematic risk in the form of high default correlation means that there is a significant chance of a large number of defaults occurring simultaneously across the market. For senior bonds in a CDO structure, this high systematic risk can lead to large losses. Even though the expected loss may be lower due to the diversification of the underlying loan pool, the tail risk, as reflected in the high Credit VaR (Value at Risk), is substantial. This indicates that senior bonds, despite being at the top of the payment hierarchy, are still vulnerable to market-wide shocks and can incur significant losses under high default correlation scenarios.

A is incorrect because systematic risk related to default correlation does not directly lead to liquidity risk for senior bonds. The primary concern is the potential for large credit losses.

B is incorrect as the scenario specifically highlights the increased risk of large losses in senior bonds due to systematic risk, not lower expected losses.

D is incorrect because even with diversified collateral, high systematic risk can still significantly affect the senior bonds, increasing their exposure to potential losses, not reducing it.

Things to Remember

• In a CDO structure, high systematic risk manifested through default correlation increases the potential for large losses in senior bonds. This is primarily because systematic risk affects a large number of assets simultaneously, leading to widespread defaults.
• Senior bonds, typically perceived as lower risk due to their priority in payment, can still face significant losses in scenarios with high default correlation across the market.
• The concept of Credit VaR (Value at Risk) is crucial in understanding the risk exposure of senior bonds in CDOs under systematic risk. It quantifies the extreme loss potential that these bonds could face during market-wide stress events.