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FRM Part II · FRM Exam Part II · Credit Derivatives

Two CDO tranche investors hold exposure to the same reference portfolio. If the average default correlation among the underlying names increases, with the portfolio's expected loss unchanged, what is the typical effect on the value of the equity tranche and the senior tranche?

The equity tranche gains value and the senior tranche loses value. Higher correlation raises the chance of both very few defaults and very many, helping the equity holder, who is long correlation, while making senior losses more likely, hurting the senior holder, who is short correlation.

  1. AEquity tranche value rises and senior tranche value fallsCorrect
  2. BEquity tranche value falls and senior tranche value rises
  3. CBoth tranche values rise because total risk is unchanged
  4. DBoth tranche values fall because expected loss is unchanged

Explanation

Higher correlation fattens both tails of the portfolio loss distribution: more probability of very few defaults (good for equity, which is long correlation) and more probability of extreme losses reaching the senior tranche (bad for senior, which is short correlation). Expected loss is conserved across the capital structure, so gains and losses redistribute.

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