A CDO has three tranches, a senior tranche, mezzanine tranche, and equity tranche. Keeping the probabilities of default in the CDO collateral fixed, the value of the equity tranche increases if
A) The correlation of default across all names in the CDO increases.
B) The correlation of default across all names in the CDO decreases.
C) The credit quality of names in the CDO collateral declines.
D) The volatility of credit spreads on names in the CDO collateral increases.

Question

A CDO has three tranches, a senior tranche, mezzanine tranche, and equity tranche. Keeping the probabilities of default in the CDO collateral fixed, the value of the equity tranche increases if 
A) The correlation of default across all names in the CDO increases.
B) The correlation of default across all names in the CDO decreases.
C) The credit quality of names in the CDO collateral declines.
D) The volatility of credit spreads on names in the CDO collateral increases.

Quizplus · Accepted Answer

When the correlation of default across all names in the CDO increases, the likelihood of extreme outcomes (either all defaults or no defaults) increases. This benefits the equity tranche, which is the first to absorb losses but also benefits from the remaining value if defaults are low.

A CDO Has Three Tranches, a Senior Tranche, Mezzanine Tranche