Skip to content

FRM Part II · FRM Exam Part II · Credit Derivatives

A risk manager reviews a CDO-squared structure, whose collateral consists of mezzanine tranches of other CDOs. Compared with a single-layer CDO on a similar underlying pool, which feature should the manager expect?

A CDO-squared is more leveraged and far more sensitive to correlation and model assumptions. Its collateral is mezzanine tranches that already carry leveraged exposure to the same underlying names, so re-tranching magnifies losses in stressed scenarios rather than diversifying them.

  1. ALower sensitivity to correlation, since diversification across CDOs removes common risk
  2. BGreater sensitivity to model assumptions and a more leveraged exposure to underlying defaultsCorrect
  3. CIdentical loss distribution because the underlying names are unchanged
  4. DHigher recovery because tranches rank above the underlying bonds

Explanation

Re-tranching mezzanine pieces creates a second layer of leverage and concentrates exposure to overlapping underlying names, so outcomes are highly sensitive to correlation and model assumptions. Diversification is limited by overlap, and tranches do not improve recovery.

Did you get it right without looking?

One question tells you little. A timed set on Credit Derivatives shows your real accuracy, how long you take and where you lose marks.

Practise Credit DerivativesFree diagnostic mock

More Credit Derivatives questions