CFA Level I · CFA Level I Exam · Asset-Backed Security (ABS) Instrument and Market Features
Compared with a CDO backed by a diversified pool, a CDO whose collateral pool assets have high default correlation would most likely expose the senior tranche to:
High default correlation raises the risk to the senior tranche, because defaults tend to cluster and large pool losses become more likely. Such losses can exhaust the subordinated tranches and reach the senior tranche, even though the size of subordination has not changed.
- Alower risk of loss, because the equity tranche is larger
- Ba greater risk of loss, because defaults tend to clusterCorrect
- Cthe same risk of loss, because subordination is unchanged
Explanation
High default correlation means defaults tend to occur together, so pool losses are more likely to be large enough to exhaust subordinated tranches and reach the senior tranche. Subordination is unchanged in size but is less likely to be sufficient.
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