Credit Risk Management Practice Exam

How does overcollateralization improve the security of senior tranches?

1. It increases payment delays for junior tranches

2. It buffers senior tranches from losses

3. It guarantees higher interest rates for investors

4. It enables the restructure of debt agreements

The correct answer is: It buffers senior tranches from losses

Overcollateralization improves the security of senior tranches primarily by creating a buffer against potential losses. In a structured finance context, overcollateralization occurs when the value of the collateral backing the securities is greater than the total value of the securities issued. This surplus in collateral means that should the assets underperform or default, the senior tranches are prioritized in the claim on the collateral, protecting them from losses that may affect lower-ranking tranches. By having additional collateral available, any losses incurred by the underlying assets are absorbed first by the junior tranches, which are subordinate to the senior tranches. As a result, the risk to investors in the senior tranches is significantly reduced, enhancing their security. This makes senior tranches more attractive to investors since they are perceived to be safer investments due to the lower likelihood of loss. The other options either do not accurately describe the function of overcollateralization or relate to concepts that do not directly contribute to the security of senior tranches. For instance, increasing payment delays for junior tranches does not inherently enhance the security of senior tranches and could instead create liquidity issues. Similarly, guaranteeing higher interest rates for investors is not a direct outcome of overcollateralization, as the interest rate