CFA Level I · CFA Level I Exam · Asset-Backed Security (ABS) Instrument and Market Features
A CDO has a senior tranche, a mezzanine tranche and an equity tranche. Collateral losses first occur and are small. Which tranche most likely absorbs these losses first?
The equity tranche absorbs the losses first. In a CDO waterfall, losses reduce the equity (first-loss) tranche before the mezzanine, and the senior tranche is hit last. That is why equity is the riskiest tranche and the senior tranche has the greatest credit protection.
- ASenior tranche
- BEquity trancheCorrect
- CMezzanine tranche
Explanation
CDO tranches follow a loss-allocation waterfall: the equity (first-loss) tranche absorbs losses first, then the mezzanine, and finally the senior tranche. Small losses therefore fall on the equity tranche, which is why it is the riskiest and offers the highest potential return.
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