Credit Risk Management Practice Exam

What effect does an increase in default probabilities have on all tranches in a securitization?

1. It increases risk for senior tranches only

2. It has no effect on equity tranches

3. It decreases the value at risk for all tranches

4. It decreases all tranches unconditionally

The correct answer is: It decreases all tranches unconditionally

An increase in default probabilities generally signifies a higher likelihood that underlying assets will not perform as expected, leading to potential losses for all investors in the securitization structure. This shift in risk impacts each tranche differently based on its place within the capital structure, but ultimately, it decreases the value of each tranche due to heightened credit risk. Senior tranches often have some level of protection from losses due to their preferential claim on cash flows; however, if default probabilities rise significantly, even these tranches face increased credit risk, which can lead to a decrease in their pricing and an increase in their yield demands. This reflects the market's adjusted perception of risk, as investors require higher compensation for taking on increased risk. Equity tranches are the first to absorb losses in a securitization structure and have no such loss protection. As default probabilities rise, equity tranches are likely to see a decline in value more dramatically than higher-ranked tranches since they will absorb losses before any other members of the securitization structure. Therefore, as default probabilities rise, it creates negative pressure on the perceived value of all tranches, leading to decreased valuations across the board. This adjustment reflects the heightened risk of loss across the entire security. Understanding this dynamic showcases the