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FRM Part II · FRM Exam Part II · Credit Derivatives

A risk manager analyses a synthetic CDO on a diversified portfolio under a one-factor Gaussian copula. Asset correlation across all names is increased while average portfolio spread stays fixed. Which combination of changes in tranche values is most likely?

The equity tranche gains value while the senior tranche loses value. Higher correlation leaves total expected loss unchanged but shifts it toward the tail, making few defaults and mass defaults both likelier. Equity expected loss falls, and senior expected loss rises, so equity is long correlation and senior is short.

  1. AEquity tranche value rises, senior tranche value fallsCorrect
  2. BEquity tranche value falls, senior tranche value rises
  3. CBoth equity and senior tranche values fall, with mezzanine unchanged
  4. DBoth equity and senior tranche values rise, as total expected loss grows

Explanation

Expected portfolio loss is unchanged, so correlation only redistributes it. Higher correlation raises the probability of very few defaults (benefiting equity, which is long correlation) and also of many defaults (hurting senior, which is short correlation). The equity tranche's expected loss falls and its value rises, while senior expected loss rises and its value falls. Mezzanine sensitivity is ambiguous, not unchanged by rule.

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