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FRM Part II · FRM Exam Part II · Credit Derivatives

A bank holds a cash CDO with an equity tranche (0%-5%), a mezzanine tranche (5%-15%) and a senior tranche (15%-100%) on a reference portfolio. Which statement correctly describes how credit losses on the underlying portfolio are allocated?

Losses are absorbed in order of subordination: the equity tranche first, then the mezzanine, and finally the senior tranche. This waterfall is what makes the senior tranche safer and the equity tranche riskiest, rather than losses being shared pro rata by notional.

  1. ALosses are shared pro rata across all tranches according to their notional amounts
  2. BLosses are absorbed first by the equity tranche, then by the mezzanine tranche, and only then by the senior trancheCorrect
  3. CLosses are absorbed first by the senior tranche because it has the largest notional
  4. DLosses are absorbed by the mezzanine tranche first because it has the highest spread per unit of risk

Explanation

CDO tranches are subordinated: the first portfolio losses hit the equity tranche until its 5% is exhausted, then the mezzanine tranche up to 15% cumulative loss, and the senior tranche only after that. Pro rata sharing would apply to a single pass-through pool, not a tranched structure.

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