A second-to-default (STD) basket option pays off when any one of the companies in a credit basket defaults. The price of the STD basket increases when
A) The credit quality of any issuer in the basket improves.
B) The correlation of default across names in the basket increases.
C) The correlation of default across names in the basket decreases.
D) The volatility of credit spreads for names in the basket decreases.

Question

A second-to-default (STD) basket option pays off when any one of the companies in a credit basket defaults. The price of the STD basket increases when 
A) The credit quality of any issuer in the basket improves.
B) The correlation of default across names in the basket increases.
C) The correlation of default across names in the basket decreases.
D) The volatility of credit spreads for names in the basket decreases.

Quizplus · Accepted Answer

CThe price of a second-to-default (STD) basket option increases when the correlation of default across names in the basket increases (B) because higher correlation means it's more likely that defaults will cluster, making the second default more predictable and the option more valuable. Conversely, when the correlation decreases (C), it implies that defaults are less likely to happen at the same time, increasing the risk that the option will have to pay out, thus increasing its price due to higher risk.

A Second-To-Default (STD) Basket Option Pays Off When Any One