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

A rating analyst compares two ABS pools with identical average default probability and recovery. Pool A has low asset correlation among its loans, while Pool B has high asset correlation. All else equal, which statement about the effect on tranches is most accurate?

Higher correlation raises the senior tranche's expected loss and lowers the equity tranche's expected loss. Pool expected loss is unchanged, but correlation fattens both tails of the loss distribution: severe systemic losses reach senior holders more often, while equity more often escapes losses.

  1. AThe senior tranche of Pool B has higher expected loss than that of Pool A, while the equity tranche of Pool B has lower expected lossCorrect
  2. BBoth the senior and equity tranches of Pool B have higher expected loss than in Pool A
  3. CThe senior tranche of Pool B has lower expected loss than that of Pool A, while the equity tranche of Pool B has higher expected loss
  4. DCorrelation changes only the pool's expected loss, so tranche losses are unchanged

Explanation

Pool expected loss is unchanged by correlation, but the loss distribution shifts. Higher correlation fattens the tails: extreme losses become more likely, raising senior tranche expected loss, while more scenarios with very few defaults reduce equity expected loss. Hence senior is hurt and equity benefits. The option claiming the reverse reflects the diversification intuition applied to the wrong tranche.

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