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

A structure has a pool of USD 200 million with a senior tranche of USD 160 million, and USD 8 million of excess spread is expected annually. Initial credit enhancement is only subordination of 20%. Which statement about adding a reserve account funded from excess spread is correct?

A reserve account from excess spread adds protection by trapping cash, but it only builds up if the pool actually generates and retains excess spread. In stress, spread can shrink, so it is not a guarantee and it supplements rather than replaces subordination.

  1. AIt increases the credit enhancement only if the pool's default correlation falls to zero
  2. BIt replaces subordination because both are the same type of internal enhancement
  3. CIt increases senior protection by trapping cash, but its benefit depends on excess spread actually being generated and retainedCorrect
  4. DIt guarantees the senior tranche against any pool loss up to the reserve amount regardless of performance

Explanation

A reserve account built from trapped excess spread adds a loss buffer ahead of the senior tranche, but it is funded only if the pool generates spread after losses and costs. In stressed scenarios the spread can disappear, so the protection is not guaranteed. It supplements rather than replaces subordination, and it does not depend on correlation being zero.

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