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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

Before 2007, many investors bought senior CDO tranches relying mainly on high agency ratings. Which lesson about credit risk transfer does this best illustrate?

Ratings on structured products can understate risk because they rely on model assumptions about correlation and housing prices that may be wrong. The crisis showed that investors need their own independent due diligence rather than relying only on agency ratings for senior CDO tranches.

  1. ARatings on structured products can understate risk when correlation and model assumptions are flawed, so investors need independent analysisCorrect
  2. BRatings on structured products are always more reliable than ratings on corporate bonds
  3. CSenior tranches cannot lose value unless all tranches are wiped out
  4. DTransfer of credit risk removes all systemic risk from the banking system

Explanation

Structured ratings relied on models with assumptions about default correlation and housing prices that proved wrong, and senior tranches suffered large losses and mark-to-market falls. Investors should not rely solely on ratings. The other options overstate safety.

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