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FRM Part II · FRM Exam Part II · Credit Derivatives

A portfolio manager holds a senior tranche of a synthetic CDO. Default correlation among the reference entities increases sharply while individual default probabilities stay unchanged. Holding other factors constant, what is the most likely effect on the tranche values?

Senior tranche value falls and equity tranche value rises. Higher correlation raises the chance of clustered defaults that reach the senior tranche, while making a low-loss outcome more likely, which helps equity. Expected pool loss is unchanged, but tranche payoffs are nonlinear in portfolio loss.

  1. ASenior tranche value falls and equity tranche value risesCorrect
  2. BSenior tranche value rises and equity tranche value falls
  3. CBoth senior and equity tranche values rise
  4. DBoth tranche values are unchanged because expected portfolio loss is unchanged

Explanation

Higher correlation fattens the tail of the portfolio loss distribution: more probability of very few defaults and also of many simultaneous defaults. The senior tranche, exposed to the tail, becomes riskier and loses value. The equity tranche benefits as the probability of the first losses being large declines, so its value rises. Expected portfolio loss is unchanged but tranche losses are not linear in it.

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