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

A risk manager compares two CDO structures backed by identical loan pools with identical expected pool loss. In Structure B, the underlying assets are much more highly correlated than in Structure A. Holding the tranche structure fixed, which is the most likely effect of the higher correlation on the tranches in Structure B?

Higher asset correlation lowers the equity tranche's expected loss and raises senior tranche risk. Correlation makes defaults cluster, so low-loss scenarios become more likely, which helps equity, while extreme-loss scenarios become more likely, which reaches the senior tranches. Total pool expected loss stays the same.

  1. AEquity tranche expected loss rises and senior tranche risk falls
  2. BEquity tranche expected loss falls and senior tranche risk risesCorrect
  3. CExpected losses of all tranches rise equally
  4. DExpected losses of all tranches fall equally

Explanation

Higher correlation fattens the tails of the pool loss distribution: scenarios with very few defaults and with very many defaults both become more likely. The equity tranche benefits from more benign outcomes, so its expected loss falls, while the senior tranche is more likely to be hit in systemic scenarios, so its risk rises. Pool expected loss is unchanged, so effects cannot be uniform.

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