Dear Alll:
According to the problem below, why is it that the default correlation are lower?
Thank yoo so much for your time
Which of the following most accurately describes the pricing of a first-to-default basket of credit default swaps in a correlation trade? The swap premium will be higher when the number of credit default swaps is:
A) higher and when the default correlations are lower. B) higher and when the default correlations are higher. C) lower and when the default correlations are higher.
Your answer: A was correct!
In one type of correlation trade, the investor sells protection on a basket of credit default swaps. One such basket is a first-to-default swap, where the number of credit default swaps in the basket is typically five. In this structure, the investor would provide protection for the first (and only the first) default. If one of the reference obligations defaults, the investor owes the basket’s notional amount and receives the defaulted reference obligation. The pricing of the basket default swap depends on the default correlation, which is the probability that two of the reference obligations in a basket will default concurrently. Higher default correlations result in lower premiums (the protection offered by the first-to-default basket is worth less to the protection buyer when it is likely that several of the obligations will default at the same time). The higher the number of credit default swaps in the basket, the higher the basket’s premium (there is a greater probability of one of them defaulting).