Which of the following happens when the default correlation of the companies underlying a CDO increases?
A. The value of the senior tranche and the equity tranche to the protection buyer both increase
B. The value of the senior tranche and the equity tranche to the protection buyer both decrease
C. The value of the senior tranche to the protection buyer decreases and the value of the equity tranche to the protection buyer increases
D. The value of the senior tranche to the protection buyer increases and the value of the equity tranche to the protection buyer decreases
D
Senior tranches are more likely to experience losses and so their value to the protection buyer increases. The equity tranche is less likely to experience losses and so its value to the protection buyer decreases. (The total expected loss of all tranches stays the same.) This answer is best understood by thinking about the situation where every company has a 2% probability of defaulting. What is the situation if the correlation is zero? What is the situation when the correlation is perfect?
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