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FRM Part II · FRM Exam Part II · Structured Credit Risk

A bank analyst compares two tranches of the same CDO. The senior tranche sits above a 12% attachment point, while the equity tranche absorbs the first losses. Which statement best describes why the senior tranche usually receives a higher rating than the average rating of the underlying collateral?

The senior tranche is rated higher because subordinated tranches absorb losses first. Collateral pool losses must exceed the senior attachment point, here 12%, before the senior investors lose anything. All tranches claim the same pool, so the rating uplift comes from subordination, not from different assets.

  1. ACredit enhancement through subordination means the collateral pool must lose more than the attachment point before the senior tranche takes any lossCorrect
  2. BThe senior tranche holds the highest-rated assets in the pool while the equity tranche holds the lowest-rated assets
  3. CThe senior tranche has a shorter legal maturity than every other tranche, which removes default risk
  4. DThe senior tranche is guaranteed by the servicer, which pays any shortfall in collateral cash flows

Explanation

Tranche ratings reflect the credit enhancement provided by subordinated tranches. Pool losses must exceed the 12% attachment point before the senior tranche is impaired. Tranches share the same pool; they do not hold different assets, and servicers do not guarantee cash flows.

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