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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

A structured finance analyst compares a AAA-rated corporate bond with a AAA-rated senior tranche of a mortgage CDO. Which statement best describes why the two ratings are not equivalent in risk terms?

The AAA CDO tranche is a leveraged exposure to systematic risk and depends heavily on correlation and model assumptions, so its rating can migrate much more sharply in a downturn than a AAA corporate bond, despite the same rating label.

  1. AThe CDO tranche rating is driven mainly by idiosyncratic risk, so it is more stable under stress
  2. BThe CDO tranche has greater exposure to systematic risk and model uncertainty, so its rating is more likely to migrate sharply in a downturnCorrect
  3. CCorporate bond ratings include liquidity risk, whereas CDO ratings do not
  4. DThe two ratings are equivalent because the rating scale is identical

Explanation

Senior structured tranches are leveraged claims on systematic risk: small changes in pool default rates or correlation can move them from nearly riskless to impaired. Their ratings are therefore more sensitive to model assumptions and show larger migration. Idiosyncratic risk is diversified away in the pool, so option A has the logic reversed.

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