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

A risk manager reviews a rating agency's approach to rating a CDO of corporate bonds. The agency uses a Monte Carlo simulation of pool defaults with a Gaussian copula. The manager wants to know the effect of raising the asset correlation assumption, keeping each bond's default probability unchanged. Which outcome is most likely?

Higher correlation with unchanged default probabilities leaves expected pool loss the same but shifts risk into the tails. Large joint-default events become more likely, raising senior tranche loss risk, while the chance of few defaults rises, lowering expected loss on the equity tranche.

  1. AExpected pool loss rises materially, so all tranches lose value equally
  2. BSenior tranche loss probability rises, while equity tranche expected loss tends to fallCorrect
  3. CSenior tranche loss probability falls, while equity tranche expected loss rises
  4. DBoth senior and equity tranche expected losses fall because diversification increases

Explanation

Expected pool loss depends only on marginal default probabilities and recoveries, so it is unchanged. Higher correlation fattens the tail of the loss distribution, increasing the chance of very large losses that hit senior tranches. It also raises the probability of zero or few defaults, which reduces equity expected loss.

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