Q. Which statement best describes the risk to senior tranche investors in a collateralized debt obligation (CDO)?
- There are no triggers that require the payoff of the principal to investors.
- In default, the manager will not earn a return sufficient to payoff investors.
- Leverage inherent in the CDO transaction results in higher risk.
Solution
B is correct ( WHY C IS WRONG???)
Option B is correct indeed.
Option A is wrong because that clause is present for credit card receivables.
Option C is wrong because we are discussing the risk of the senior tranche of the CDO. The CDO manager is more exposed to Leverage risk in this case.
CDO is leveraged buying of securities and giving their returns to various borrowers. So, in case of default the manager will not be able to make these payments and hence Option B is correct.