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FRM Part II · FRM Exam Part II · Structured Credit Risk

A risk manager compares two mezzanine tranches on identical pools. Tranche A has attachment 5% and detachment 10%. Tranche B has attachment 5% and detachment 20%. Holding pool default probabilities and correlations constant, which conclusion is most appropriate?

Tranche B has the lower expected loss rate. Both begin absorbing losses at 5%, but the thin tranche A is exhausted at 10% pool loss, whereas B's wider band means the same pool loss consumes only part of its principal.

  1. ATranche A has the same expected loss rate because the attachment point is the same
  2. BTranche A has lower expected loss because its detachment point is lower
  3. CTranche B has a lower expected loss rate because its thicker width spreads losses over a larger notionalCorrect
  4. DTranche B has a higher expected loss rate because it detaches higher

Explanation

Both tranches suffer first-dollar loss at 5%. Tranche A is fully wiped out once pool losses reach 10%, while B loses only a fraction of its notional at that level. The thicker tranche therefore has a lower loss as a percent of its notional, and so a lower expected loss rate. Detachment matters, so equal attachment does not mean equal risk.

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