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FRM Part II · FRM Exam Part II · Credit Risk Management

In a cash securitization, a senior tranche is rated AAA because the pool is subordinated by a mezzanine and an equity tranche. A risk manager reviews the pool and finds that the underlying loans are highly concentrated in one region with strongly correlated defaults. Compared with a pool of the same expected loss but low default correlation, what is the most likely effect on the senior tranche?

Senior tranche risk rises. With the same expected loss, higher default correlation makes very large pool losses more likely, and these are the outcomes that exhaust subordination and hit the senior tranche. Equity tranches tend to benefit, but senior tranches become more exposed.

  1. AIts risk of loss increases, because higher correlation raises the probability of extreme pool losses reaching the senior trancheCorrect
  2. BIts risk of loss decreases, because higher correlation reduces the chance of pool losses reaching the senior tranche
  3. CIts risk is unchanged, because expected pool loss is unchanged
  4. DIts risk is unchanged, because subordination fully protects it

Explanation

Higher correlation fattens the tail of the pool loss distribution. Equity tranche risk tends to fall slightly while senior tranche risk rises, as extreme losses become more likely even with equal expected loss. Subordination is finite and does not protect against extreme outcomes.

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