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

An investor compares a sequential-pay structure with a pro rata structure for a pool with senior and subordinated tranches. Which statement correctly describes sequential-pay?

In a sequential-pay structure, principal collections go to the senior tranche until it is fully repaid, then to the next tranche. This builds up subordination beneath the senior notes over time, unlike pro rata sharing by balance.

  1. APrincipal repayments go to the senior tranche first until it is fully repaid, before subordinated tranches receive principalCorrect
  2. BPrincipal is shared among all tranches in proportion to their balances at all times
  3. CPrincipal goes first to the equity tranche to remove the first-loss risk
  4. DInterest is paid to the junior tranche before the senior tranche

Explanation

In a sequential structure, principal collections retire the senior tranche first, then the next, which increases subordination for the senior over time. Pro rata shares principal by balance. Interest follows the priority of seniority, not junior first.

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