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FRM Part II · FRM Exam Part II · Credit Derivatives

A cash CDO is backed by a diversified pool of corporate bonds and issues equity, mezzanine and senior tranches. A risk analyst states that the equity tranche is the first to absorb losses. Which statement best describes the equity tranche's position in the capital structure?

The equity tranche absorbs the first losses on the collateral pool and, as compensation for that risk, offers the highest promised spread or residual return. Losses move up the structure only after equity is wiped out, while interest and principal are paid to senior tranches first.

  1. AIt absorbs losses last and therefore has the lowest expected return
  2. BIt absorbs the first losses on the pool and receives the highest promised spreadCorrect
  3. CIt is paid before the mezzanine tranche in the interest waterfall
  4. DIt is insulated from losses until the senior tranche is exhausted

Explanation

Losses on the collateral are allocated from the bottom of the capital structure upward, so the equity tranche takes losses first. To compensate for this risk it receives the highest promised spread or residual return. The other options describe senior-tranche features or reverse the waterfall.

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