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FRM Part II · FRM Exam Part II · Structured Credit Risk

A CLO manager is evaluating a mezzanine tranche attaching at 5% and detaching at 12% of a loan pool. The pool's average default correlation is expected to rise materially, with expected portfolio loss unchanged. Holding all else equal, what is the most likely effect on the value of the equity tranche and the senior tranche?

Equity tranche value rises and senior tranche value falls. With expected pool loss fixed, higher default correlation makes outcomes more clustered: there are more scenarios with few defaults, which benefits the first-loss equity, and more extreme joint-default scenarios, which threaten senior tranches.

  1. AEquity tranche value falls and senior tranche value rises
  2. BEquity tranche value rises and senior tranche value fallsCorrect
  3. CBoth tranches rise because expected pool loss is unchanged
  4. DBoth tranches fall because higher correlation increases expected pool loss

Explanation

Higher correlation fattens both tails of the loss distribution: more scenarios with very few defaults (helping equity, which loses only if early defaults occur) and more scenarios with massive joint defaults (hurting senior). Expected pool loss is unchanged, so equity gains while senior loses. The claim that expected loss rises is wrong by assumption.

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