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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

A bank values an illiquid structured credit position using a model with an input assumption of 2% default correlation drawn from a benchmark period of stable markets. In a crisis, observed correlations rise to levels well above this assumption. Which statement best describes the resulting valuation failure, as seen in the 2007-2009 crisis for senior CDO tranches?

Senior CDO tranche values were overstated because models used low correlation assumptions and understated joint default probability. Higher correlation raises the chance of clustered defaults, which damages senior tranches that were thought nearly safe. Correlation does matter for tranche values, and equity tranches typically benefit rather than suffer from higher correlation.

  1. ASenior tranche values were overstated because the models understated the probability of joint defaults, which hits senior tranches harder than assumedCorrect
  2. BSenior tranche values were understated because higher correlation reduces the loss to senior holders
  3. CEquity tranche values were overstated because higher correlation raises the expected equity loss
  4. DValuations were unaffected because tranche cash flows are independent of correlation

Explanation

Senior tranches lose value only when many defaults occur together. Higher correlation increases the probability of clustered defaults, so senior tranche risk rises and value falls, while models assumed low correlation. Equity tranches actually tend to benefit from higher correlation, so the equity option is wrong.

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