Question

Which of the four standard “tranches” of a CDO is riskiest from an investor’s standpoint and why

Answer 1

A collateralized debt obligation (CDO) is usually divided into four tranches which receive the cash flows of interest and principal repayments in order of the each tranche's seniority. The seniormost tranche gets paid first and consequently, if some cash flows default, the juniormost tranche is the first to suffer losses. In such a scenario the senior-most tranche keeps earning cash flows at the expense of the tranches below it, thereby being the last to lose payment and hence are the safest. Consequently, the senior-most tranche has the lowest interest rates and the junior most tranche has the highest interest rate on account of it being the riskiest from the investor's standpoint. The highest risk undertaken by the junior-most tranche investors need to be compensated for by the highest rate of interest which is what the case is in reality.