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FRM Part II · FRM Exam Part II · Credit Derivatives

A synthetic CDO references a portfolio of USD 1,000 million. The mezzanine tranche attaches at 4% and detaches at 10%. Cumulative portfolio losses reach USD 75 million, with no recoveries beyond those already netted in the loss figure. What is the loss borne by the mezzanine tranche holders, and what fraction of the tranche notional is that?

The mezzanine tranche loses USD 35 million, or 58.3% of its USD 60 million notional. Losses of USD 75 million exceed the USD 40 million attachment point by USD 35 million, and the tranche only covers losses between USD 40 million and USD 100 million.

  1. AUSD 35 million, which is 58.3% of the tranche notionalCorrect
  2. BUSD 75 million, which is 100% of the tranche notional
  3. CUSD 40 million, which is 66.7% of the tranche notional
  4. DUSD 35 million, which is 35.0% of the tranche notional

Explanation

Attachment is 4% x 1,000 = USD 40m and detachment is USD 100m, so tranche notional is USD 60m. Portfolio loss of 75 exceeds the attachment by 35, so the mezzanine loss is 35. 35/60 = 58.3%. Option 3 divides the wrong way or uses the attachment point as the loss.

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