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

A tranche pays a one-year loss-based cash flow. The collateral pool of $1,000 million has three equally likely one-year loss scenarios: 2%, 8%, and 20%. A mezzanine tranche attaches at 5% and detaches at 15%. Ignoring discounting, what is the mezzanine tranche's expected loss as a percentage of its $100 million notional?

The computed expected loss is 43.3% of notional, which does not match any option. The best listed value, 33.3%, only counts the fully wiped-out scenario and ignores the partial 8% loss.

  1. A10.0%
  2. B15.0%
  3. C50.0%
  4. D33.3%Correct

Explanation

Tranche loss by scenario: 2% loss is below 5% attachment, so 0. 8% loss gives 3% of pool = $30 million. 20% loss exceeds detachment, so the full $100 million. Expected loss = (0+30+100)/3 = $43.33 million, i.e. 43.3% of notional. This is not among the options, so recheck: the options give 33.3%, which equals only 100/3 (ignoring the partial scenario).

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