Explanation:
Selling default protection on a CDO tranche means the firm is "long" the credit risk of that tranche; it receives premium payments but must pay out if the tranche experiences losses due to defaults.
For the senior tranche, defaults only cause losses if a catastrophic number of simultaneous defaults occur in the underlying portfolio, enough to wipe out the equity and mezzanine tranches. If default correlation decreases, defaults become less clustered and more independent. This significantly reduces the probability of a large number of defaults occurring at the same time. Consequently, the probability of the senior tranche suffering losses decreases.
As the probability of payout falls, the expected losses for the protection seller decrease, meaning the value of the short protection position (from the seller's perspective) increases or gains value.
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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