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Explanation:
By using varying correlation assumptions for each tranche to match observed market prices, the base correlation is essential for describing the tranche-specific behaviors and dependencies between tranches, maturing the equity correlation assumption to better align with the reality of the full capital structure in the CDO market.
A is incorrect. Recovery rates are not directly related to correlation assumptions in the base correlation approach.
B is incorrect. Base correlation is not about a single correlation value but rather revising that assumption over different tranches.
D is incorrect. Base correlation does not simply apply the equity tranche correlation to all other tranches. Instead, it calculates distinct correlations for each tranche.
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Q.6086 Base correlation rectifies the shortcomings of using a single correlation figure for the entire capital structure by introducing a more nuanced approach. In practice, how is the base correlation approach used in the valuation of CDO tranches?
A
By assigning different recovery rates to each tranche based on their seniority.
B
By calculating a single correlation value that matches the market price of only the equity tranche.
C
By using varying correlation assumptions for each tranche to match observed market prices.
D
By applying the correlation assumption of the equity tranche to all the remaining tranches.