If you expect default correlations to increase in the future, what trade might you engage in to profit from this view?
A) Buy the senior tranche of a CDO.
B) Buy a second-to-default basket option and sell a first-to-default basket.
C) Sell a second-to-default basket option and buy a first-to-default basket.
D) Short the equity tranche of a CDO.

Question

If you expect default correlations to increase in the future, what trade might you engage in to profit from this view? 
A) Buy the senior tranche of a CDO.
B) Buy a second-to-default basket option and sell a first-to-default basket.
C) Sell a second-to-default basket option and buy a first-to-default basket.
D) Short the equity tranche of a CDO.

Quizplus · Accepted Answer

Buying a second-to-default basket option and selling a first-to-default basket is a strategy that profits from an increase in default correlations. When default correlations rise, the likelihood of multiple companies in a sector or region defaulting together increases. This increases the likelihood of a second-to-default event (i.e., the second company in the portfolio to default) occurring. By buying a second-to-default basket option and selling a first-to-default basket, an investor can profit from this phenomenon.

If You Expect Default Correlations to Increase in the Future