Financial Risk Manager Part 1
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In the structure of Asset-Backed Securities (ABSs), the senior tranche is typically assigned the highest rating, while the equity tranche is expected to yield the highest returns. This is due to the risk-return trade-off inherent in these securities.
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Explanation:
Explanation
In Asset-Backed Securities (ABS) structures:
Senior Tranche:
- Receives cash flows first from the underlying assets
- Least exposed to default risk
- Typically assigned the highest credit rating (often AAA)
- Offers lower returns due to lower risk
Equity Tranche:
- Receives cash flows last
- Bears the first losses if underlying assets default
- Most risky tranche
- Often unrated
- Offers the highest expected returns to compensate for higher risk
Mezzanine Tranche:
- Falls between senior and equity tranches
- Moderate risk and return profile
Why Choice C is correct:
- Senior tranches get highest ratings due to lower risk
- Equity tranches yield highest returns due to higher risk
- This reflects the fundamental risk-return trade-off in finance
Why other choices are incorrect:
- A: Senior tranches have high ratings but NOT highest returns
- B: Equity tranches have highest returns but NOT highest ratings
- D: Equity tranches cannot have both highest ratings and returns; mezzanine doesn't yield highest returns
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