Skip to content

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

A structured credit desk prices a CDO tranche with a Gaussian copula and notes that the Gaussian copula has zero tail dependence. Which implication is most accurate for the risk assessment of a senior tranche?

Senior tranche risk may be understated. The Gaussian copula has no tail dependence, so it assigns too little probability to many simultaneous extreme defaults, which are exactly the events that cause losses to senior tranches in a crisis.

  1. ASenior tranche losses will be overstated because extreme joint defaults are too likely
  2. BSenior tranche risk may be understated because joint extreme defaults in a crisis are assigned too little probabilityCorrect
  3. CTranche values become independent of the correlation parameter
  4. DThe model will price all tranches identically

Explanation

With zero tail dependence, defaults become nearly independent in the extreme tail even at high correlation, so clustering of defaults in a crisis is underestimated. This hurts senior tranches most because they lose only when many names default. Overstatement is the opposite of the effect.

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