Skip to content

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

An investor holds a senior tranche of a synthetic CDO and an equity tranche of a separate synthetic CDO on similar reference portfolios. Average default probabilities are unchanged, but market-implied default correlation across the reference names rises sharply. Which is the most likely effect on tranche valuations?

The equity tranche gains and the senior tranche loses. Higher default correlation makes defaults cluster, raising the chance of no or few defaults, which lowers equity expected loss, while also raising the chance of extreme portfolio losses that reach and damage the senior tranche.

  1. ABoth the equity and senior tranches gain in value
  2. BThe equity tranche gains in value and the senior tranche loses valueCorrect
  3. CThe equity tranche loses value and the senior tranche gains in value
  4. DBoth tranches lose value by the same percentage

Explanation

Higher correlation makes defaults cluster: few-default scenarios become more likely and extreme-loss scenarios also become more likely. The equity tranche, hit by the first losses, benefits from more probability of zero or few defaults, so its expected loss falls and value rises. The senior tranche is only hit in extreme scenarios, which become more likely, so its expected loss rises and value falls. The opposite pattern in the third option reverses these effects.

Did you get it right without looking?

One question tells you little. A timed set on Structured Credit Risk shows your real accuracy, how long you take and where you lose marks.

Practise Structured Credit RiskFree diagnostic mock

More Structured Credit Risk questions