Explanation:
A decrease in default correlation implies that defaults are more idiosyncratic and less likely to happen simultaneously across the underlying portfolio. For a CDO, lower correlation means that the probability of a large number of defaults occurring together—which is required to wipe out the equity and mezzanine tranches and cause losses to the senior tranche—decreases. Consequently, the senior tranche becomes safer. Since the financial firm sold protection on the senior tranche, its liability decreases as the likelihood of payouts on that tranche falls. The protection position gains significant value for the seller because they collect the premium while their risk of payout is reduced.
Ultimate access to all questions.
A
It will either increase or decrease, depending on the pricing model used and the market conditions.
B
It will gain significant value, since the probability of exercising the protection falls.
C
It will lose significant value, since the protection will gain value.
D
It will neither gain nor lose value, since only expected default losses matter and correlation does not affect expected default losses.
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