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FRM Part II · FRM Exam Part II · Credit Derivatives

In a synthetic CDO, an investor is considering the equity tranche (0-3%) and a senior tranche (15-30%) of an index. If default correlation rises while the index spread is unchanged, what is the typical effect on the tranches' values to the protection seller?

Equity tranche value to the protection seller rises and senior tranche value falls. Higher correlation makes few-default outcomes more likely, helping equity, and also makes extreme joint losses more likely, which exposes senior tranches. Equity is long correlation and senior is short correlation.

  1. AEquity tranche value rises; senior tranche value fallsCorrect
  2. BEquity tranche value falls; senior tranche value rises
  3. CBoth tranches rise in value
  4. DBoth tranches fall in value

Explanation

Higher correlation makes zero-loss outcomes more likely, so the equity tranche is less likely to be hit, benefiting the equity protection seller. It also fattens the tail, making large portfolio losses more likely, so the senior tranche is more likely to be hit and loses value to the seller. Equity is long correlation; senior is short correlation.

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