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

A synthetic CDO references a portfolio of 100 corporate names, each with a notional of USD 10 million (total USD 1,000 million). The mezzanine tranche attaches at 4% and detaches at 10%. The sponsor sells protection on this tranche. Cumulative portfolio credit losses reach USD 70 million after recoveries. What loss does the mezzanine protection seller bear?

The mezzanine protection seller bears USD 30 million. The tranche attaches at USD 40 million of portfolio losses and detaches at USD 100 million, so losses of USD 70 million exceed the attachment point by USD 30 million, which is less than the USD 60 million tranche width.

  1. AUSD 70 million
  2. BUSD 30 millionCorrect
  3. CUSD 60 million
  4. DUSD 0

Explanation

Attachment point = 4% x 1,000 = USD 40 million; detachment = USD 100 million. Portfolio losses of 70 exceed attachment by 70 - 40 = 30, which is below the tranche width of 60, so the seller bears USD 30 million. USD 70 million ignores subordination; USD 60 million assumes the tranche is fully wiped out.

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