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

An analyst notes that during a systemic downturn, senior tranches of a structured product suffered losses much larger than the pool's historical default rates suggested. What is the best explanation related to tranche risk?

The best explanation is that default correlation rose in the downturn. Higher correlation fattens the loss distribution tail, making it more likely that pool losses exceed the subordination below the senior tranche, even when average default rates are unchanged.

  1. ASenior tranches have no attachment point, so any loss reaches them
  2. BDefault correlation rose, increasing the probability of pool losses exceeding the subordination levelCorrect
  3. CSubordination is reduced automatically when ratings fall
  4. DHigher correlation lowers the loss in the tail, and so senior tranches become riskier

Explanation

Senior tranches lose only when pool losses exceed their attachment point, which is a tail event. When default correlation rises in a downturn, tail loss probability increases, so senior tranches are hurt even if average default rates were as expected. The claim that higher correlation lowers tail loss is the reverse of the true relationship.

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