Skip to content

FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

A risk manager reviews a synthetic CDO tranche priced with a one-factor Gaussian copula. Holding all other inputs constant, the pairwise default correlation among the reference entities is increased. Which statement best describes the effect on the equity tranche and the senior tranche spreads?

Equity tranche spread falls and senior tranche spread rises. Higher default correlation clusters defaults, reducing the chance of some losses that hit equity while increasing the chance of massive joint losses reaching senior tranches. Equity holders are therefore long correlation, whereas senior holders are short correlation.

  1. AEquity tranche spread falls and senior tranche spread risesCorrect
  2. BEquity tranche spread rises and senior tranche spread falls
  3. CBoth equity and senior tranche spreads rise
  4. DBoth equity and senior tranche spreads fall

Explanation

Higher correlation makes defaults cluster. Fewer small-loss scenarios occur, so the equity tranche (first loss) becomes less likely to be hit moderately and its spread falls. Joint extreme losses become more likely, so the senior tranche is more exposed and its spread rises. The option with equity rising ignores that equity is long correlation.

Did you get it right without looking?

One question tells you little. A timed set on Financial Correlation Modeling - Bottom-Up Approaches shows your real accuracy, how long you take and where you lose marks.

Practise Financial Correlation Modeling - Bottom-Up ApproachesFree diagnostic mock

More Financial Correlation Modeling - Bottom-Up Approaches questions