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FRM Part II · FRM Exam Part II · Credit Risk Management

A risk manager compares two CDO tranches on the same diversified pool: a senior tranche and an equity tranche. Asset default correlation across the pool rises sharply, with pool expected loss unchanged. Which outcome is most consistent with standard portfolio credit theory?

The equity tranche gains and the senior tranche loses. Higher correlation makes outcomes with few defaults and with massive defaults both more likely. Equity benefits from the greater chance of few losses, while the senior tranche is hurt by the greater chance of extreme losses reaching it.

  1. AEquity tranche value rises and senior tranche value fallsCorrect
  2. BBoth tranches rise in value because expected loss is unchanged
  3. CEquity tranche value falls and senior tranche value rises
  4. DBoth tranches are unaffected because expected loss is unchanged

Explanation

Higher correlation fattens both tails of the pool loss distribution: more probability of very few defaults (helping equity, whose loss is capped and convex-like) and more probability of extreme losses reaching the senior tranche. Expected pool loss is unchanged, but its allocation across tranches shifts, so equity gains and senior loses. The reverse describes low correlation.

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