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FRM Part II · FRM Exam Part II · Credit Derivatives

A CDO tranche on a standardized credit index has an attachment point of 3% and a detachment point of 7%. The underlying portfolio has notional USD 1 billion, and cumulative portfolio losses reach USD 55 million with no recoveries beyond those already netted. What loss does the tranche holder bear?

The tranche holder bears USD 25 million. The tranche absorbs losses between USD 30 million (3%) and USD 70 million (7%) of the USD 1 billion portfolio; with losses of USD 55 million, the amount above the attachment point is USD 25 million, within the 40 million width.

  1. AUSD 25 millionCorrect
  2. BUSD 40 million
  3. CUSD 52 million
  4. DUSD 15 million

Explanation

The tranche covers losses from USD 30 million to USD 70 million, a width of USD 40 million. Portfolio loss of USD 55 million exceeds the attachment by 25 million, so the tranche loses USD 25 million (62.5% of its size). USD 40 million assumes full wipeout; USD 15 million wrongly deducts the attachment from 40.

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