Series 7 practice questionhardCDOs — Tranche Risk
In a CDO structure, which tranche bears the first losses from defaults in the underlying collateral pool?
- ASenior tranche
- BMezzanine tranche
- CEquity tranche (first-loss piece)✓ Correct answer
- DAll tranches share losses equally
Explanation
Why C — Equity tranche (first-loss piece)
The equity tranche (also called the first-loss piece or residual tranche) absorbs the first losses from defaults in the underlying collateral pool. Losses are allocated from the bottom up: equity tranche first, then mezzanine, and finally senior tranche. In exchange for bearing the highest risk, the equity tranche receives the highest potential yield. The senior tranche has the most protection and typically receives the highest credit rating, often AAA.
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