CFA Level II ExamFixed IncomeEasy
A portfolio manager is analyzing a structured finance product that consists of a pool of residential mortgages. The product has multiple tranches, including a senior tranche, a mezzanine tranche, and an equity tranche. Which tranche is most exposed to credit risk from the underlying mortgages?
- AThe senior tranche.
- BThe mezzanine tranche.
- CAll tranches equally share the credit risk.
- DThe equity tranche.
Show answer & explanationAnswer & explanation
Correct answer: D. The equity tranche.
In a structured finance product, tranches are prioritized for principal and interest payments. The equity tranche is the last to receive payments and the first to absorb losses, making it the most exposed to credit risk.
Why the other options are wrong
- A. Incorrect. The senior tranche has the highest priority for payments and is therefore the least exposed to credit risk.
- B. Incorrect. The mezzanine tranche has a higher priority than the equity tranche, making it less exposed to credit risk than the equity tranche.
- C. Incorrect. Tranches are designed to allocate risk unequally, with junior tranches bearing more risk.
Structured Finance Tranche Risk
Structured finance products divide cash flows and risks from underlying assets into different tranches, with varying levels of payment priority and credit risk exposure.
- Senior tranches have highest payment priority and lowest credit risk.
- Mezzanine tranches have intermediate payment priority and risk.
- Equity (junior) tranches have lowest payment priority and highest credit risk.
Memory trick: Equity 'eats' losses first, 'leaving' senior safe.