Credit Risk Management Practice Exam

What do default sensitivities measure in a securitization context?

1. The risk associated with market volatility

2. The response of tranche value to changes in default probabilities

3. The likelihood of prepayment of loans

4. The overall performance of the collateral assets

The correct answer is: The response of tranche value to changes in default probabilities

Default sensitivities in a securitization context primarily measure how the value of a specific tranche responds to changes in the probabilities of default among the underlying assets. This concept is crucial because different tranches carry varying degrees of risk depending on their position in the capital structure. When default probabilities increase, the expected cash flows to certain tranches will diminish, impacting their value. Conversely, a decrease in default probabilities typically enhances the expected cash flows and the value of these tranches. Hence, understanding this sensitivity helps investors and risk managers to evaluate the potential impact of credit risk on investment returns and to assess the creditworthiness of different tranches within a securitized asset pool. The other options do not accurately represent the primary focus of default sensitivities. Market volatility pertains more to market risk and its effects on asset prices rather than directly measuring default risk. Prepayment likelihood relates to the early repayment of loans, which is a different aspect of credit risk. Finally, the performance of the collateral assets can be influenced by various factors beyond just default, making it a broader measure than default sensitivities specifically aim to capture.