Which of the following is true as the correlation between mortgage defaults increases?
A. Equity tranches are almost certain to incur losses
B. Senior tranches become more likely to incur losses
C. The expected number of defaults increases
D. Equity tranches are unaffected
B
If the correlation between mortgage defaults is very low the senior tranche is safe, but as the correlation increases it becomes more likely that it will experience losses. Suppose that the default probability is 2%. When correlation is zero, we expect roughly 2% of mortgages to default each year and there is virtually no chance of the senior tranche bearing losses. In the limit when default correlation between mortgages is perfect, the senior tranche has a 2% chance of bearing losses in any given year.
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