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

A risk manager reviews a synthetic CDO tranche whose value depends on the default correlation among reference entities. Under a one-factor Gaussian copula, the manager raises the asset correlation assumption from 20% to 50%. Which statement best describes the expected effect on the tranche spreads, all else equal?

Equity tranche spread falls and senior tranche spread rises. Higher correlation clusters defaults, making early losses less likely for the equity tranche but making extreme portfolio losses more likely, which raises the risk and spread of senior tranches.

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

Explanation

Higher correlation makes defaults cluster, so the probability of very few defaults increases and of many defaults increases. The equity tranche, which absorbs first losses, becomes less likely to be hit, so its spread falls. The senior tranche becomes more likely to suffer losses, so its spread rises. The reverse in option 0 describes lower correlation.

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