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FRM Part II · FRM Exam Part II · Credit Derivatives

A CDO has a reference portfolio of USD 500 million. Tranche notionals are: equity USD 25 million, mezzanine USD 75 million (attach 5%, detach 20%), senior USD 400 million. A risk manager notes that the mezzanine tranche's loss given tranche default is highly sensitive to portfolio recovery. Portfolio losses are 12% of notional. What is the mezzanine tranche's percentage loss, and what is the senior tranche's loss?

The mezzanine tranche loses 46.7% of its notional and the senior tranche loses nothing. Total losses of USD 60 million first wipe out the USD 25 million equity tranche, leaving USD 35 million for the USD 75 million mezzanine tranche, well short of reaching the senior attachment point.

  1. AMezzanine loss 46.7%; senior loss zeroCorrect
  2. BMezzanine loss 60.0%; senior loss zero
  3. CMezzanine loss 46.7%; senior loss USD 10 million
  4. DMezzanine loss 12.0%; senior loss zero

Explanation

Portfolio loss is 12% x 500 = USD 60m. Equity absorbs the first USD 25m. Mezzanine absorbs the next 35m (the loss up to 60m), out of its 75m notional: 35/75 = 46.7%. The detachment is 100m, so senior is untouched. The 60% option wrongly divides 45 by 75, double counting the equity layer.

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