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FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

A bank prices a CDO tranche using a Gaussian copula. When the implied correlation needed to match the market price of the equity tranche differs from that needed for the mezzanine tranche on the same portfolio, what does this indicate?

Different implied correlations across tranches of one portfolio show a correlation smile, indicating the single-correlation Gaussian copula does not fully reproduce market prices. It signals model misspecification rather than bad data or unusual recovery assumptions.

  1. AThe Gaussian copula with a single flat correlation does not fully capture the market's pricing, a phenomenon known as the correlation smileCorrect
  2. BThe market data are erroneous and must be discarded
  3. CThe portfolio contains names with zero default probability
  4. DThe tranche recovery rates are all equal to 100%

Explanation

Different implied (compound) correlations across tranches of the same portfolio form a correlation smile or skew, showing the single-parameter Gaussian copula is a misspecified model for the market's view of dependence.

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