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FRM Part II · FRM Exam Part II · Credit Derivatives

A cash CDO is funded by a pool of corporate loans. The structure has an equity tranche, a mezzanine tranche and a senior tranche, and pool losses are allocated in order of seniority. Which statement best describes how losses are borne when the pool suffers a small, early loss?

The equity tranche absorbs the first losses in a CDO. Losses are allocated in reverse order of seniority, so the junior piece is wiped out before the mezzanine tranche suffers anything, and the senior tranche is affected only after both subordinate tranches are exhausted.

  1. AThe senior tranche absorbs the loss first because it holds the largest notional
  2. BThe equity tranche absorbs the loss first until its principal is exhaustedCorrect
  3. CAll tranches absorb the loss pro rata to their notional amounts
  4. DThe mezzanine tranche absorbs the loss first because it has the middle rating

Explanation

Under the standard waterfall, losses hit the most junior (equity) tranche first and move up only after its principal is exhausted. Pro rata sharing applies to pass-through structures, not to tranched structures. The senior tranche is hit last.

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