Financial Risk Manager Part 1

Explanation

Asset-backed securities are divided into tranches to distribute risk according to the following structure:

Risk Hierarchy:

• Equity Tranche (Riskier): This is the riskiest tranche as it is the first to absorb losses when there are defaults on the underlying assets. Often referred to as the 'first loss' piece, this tranche takes the initial hit before any other tranches are affected.

• Mezzanine Tranche (Medium Risk): This tranche is less risky than the equity tranche but riskier than the senior tranche. It absorbs losses only after the equity tranche has been completely wiped out. It serves as a buffer between the equity and senior tranches.

• Senior Tranche (Least Risky): This is the safest tranche as it is the last to absorb losses. It is protected by both the equity and mezzanine tranches, which must be completely exhausted before the senior tranche experiences any losses.

Correct Order:

From the riskiest to the least risky: Equity tranche → Mezzanine tranche → Senior tranche

This tranching structure allows investors to choose their preferred risk-return profile, with equity tranche investors receiving higher potential returns for taking on more risk, while senior tranche investors accept lower returns for greater safety.