A. It will either increase or decrease, depending on the pricing model used and the market conditions.

B. It will gain significant value, since the probability of exercising the protection falls.

C. It will lose significant value, since the protection will gain value.

D. It will neither gain nor lose value, since only expected default losses matter and correlation does not affect expected default losses.

Correct Answer:

B

B is correct. The senior tranche will gain value if the default correlation decreases. High correlation implies that if one name defaults, a large number of other names in the CDO will also default. Low correlation implies that if one name defaults, there would be little impact on the default probability of the other names. Therefore, as the correlation decreases, the cumulative probability of enough defaults occurring to exceed the credit enhancement on the senior tranche will also decrease. Hence the investor who has sold protection on the senior tranche will see a gain.

Not sure if I understand this exam sample question. If the correlation is decrease, the senior tranche will have a low probability of default driven by the low tranche correlation. The CDS on the senior tranche will have a tighter spread, and become cheap. The seller should lose money? I am not sure why the seller will gain value.

Thanks and it is my first time post the question, hope that is in the right section.