FRM Part I · FRM Exam Part I · Banks
Which statement best describes the main purpose of tranching in a securitization of loans?
Tranching creates securities of differing seniority and risk from one pool of loans, so each can suit investors with different risk appetites. Losses hit junior tranches first, which lets senior tranches obtain higher credit ratings, but total pool risk is not eliminated.
- ATo eliminate all credit risk in the underlying pool
- BTo guarantee that every tranche earns the same yield
- CTo create securities with different seniority and risk profiles to appeal to different investorsCorrect
- DTo ensure the originator keeps full ownership of the loan cash flows
Explanation
Tranching reallocates pool cash flows and losses by seniority, creating senior, mezzanine and equity securities with different risk and return. It does not eliminate risk, equalize yields, or leave ownership with the originator.
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