Financial Risk Manager Part 1
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A financial institution has recently bundled subprime mortgages into three distinct tranches: the senior, mezzanine, and equity tranches. In terms of risk and return, how would you characterize the senior tranche in comparison to the other two tranches?
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TTanishq
A
Lower return than the equity tranche but higher return than the mezzanine tranche.
B
Higher return than the equity tranche but lower return than the mezzanine tranche.
C
Lower risk than both the equity and mezzanine tranches.
D
Lower risk than the mezzanine tranche but higher risk than the equity tranche.
Explanation:
The senior tranche of an asset-backed security, such as a mortgage-backed security, is designed to have the lowest risk among all tranches. This is because the senior tranche has the highest priority in the payment structure, meaning that it is the first to receive payments from the underlying assets. This priority payment structure significantly reduces the risk of loss for the senior tranche, making it less risky than both the equity and mezzanine tranches. However, this lower risk also means that the senior tranche typically offers lower returns compared to the other tranches. This is because in finance, there is a direct relationship between risk and return — the higher the risk, the higher the potential return, and vice versa. Therefore, the senior tranche, with its lower risk, also has lower returns compared to the equity and mezzanine tranches.
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