the answer is A, whice states that: if the correlation of the expected defaults on the CDO collateral of the senior and subordinate tranches is positive, the relative value of the mezzanine tranche compared with the senior and equity tranches will increase.
while the Schewerser notes book3 page 110 says: if the correlation of expected collateral defaults is +1, then buy equity tranch; if the correlation is -1, then buy the higest tier tranche. this means if the correlation increase, than either senior or equity tranch will increase in value relatively, but not the mezzanine.
if I understand the notes correctly, then the practice answer A is NOT RIGHT.
can anybody comfirm with that? thank you!
If the correlation is high, the prob of default will be similar across tranches >> it makes sense to buy the riskiest tranche with the highest return (i.e., equity).
If the correlation is low, the prob of default of senior is much less than the prob of default of the other tranches >> it makes sense to buy the safest tranche (i.e., senior).
The mezzanine is just between equity and senior, you can understand the rise and fall in relative value similar to the equity tranche.
thank you for help. but the answer is :the relative value of the mezzanine tranche compared with the senior and equity tranches will increase.
I do agree that mazzenine value will increase relative to senior tranches, but not to equity tranches.