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FRM Part I · FRM Exam Part I · Learning From Financial Disasters

Before the 2007-2009 crisis, rating agencies and investors valued senior CDO tranches using a Gaussian copula with a single, low default correlation estimated from a benign period. A rise in the actual correlation among underlying mortgages would most likely have which effect on the senior tranche relative to the model?

Higher actual correlation raises the likelihood of many simultaneous defaults, which is what hurts senior tranches. A model assuming low correlation therefore understated senior tranche loss probability and overvalued the tranche.

  1. AIncrease the probability of senior tranche losses, so the model overvalued itCorrect
  2. BDecrease the probability of senior tranche losses, so the model undervalued it
  3. CLeave senior tranche losses unchanged because senior tranches are immune to correlation
  4. DIncrease equity tranche losses only

Explanation

Senior tranches lose only when many assets default together. Higher correlation raises the chance of widespread simultaneous defaults, increasing senior losses. A low assumed correlation therefore overstated senior tranche value. Equity tranche risk typically falls slightly with higher correlation, so the last option is wrong.

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