Credit Risk Management Practice Exam

In a waterfall structure, who typically receives the residual cash flows after other claims are settled?

1. Senior tranche holders

2. Mezzanine tranche holders

3. Equity tranche holders

4. Underwriters

The correct answer is: Equity tranche holders

In a waterfall structure, the residual cash flows, which are the amounts remaining after all higher-priority claims have been settled, are typically allocated to equity tranche holders. The equity tranche is the lowest-ranking class of securities in the capital structure and carries the highest risk since it absorbs losses before any other tranche. Because equity tranche holders are last in line to receive payouts, they benefit from any cash flows that remain after senior and mezzanine tranche holders have been fully compensated. This structure aligns with their role as risk-takers who seek higher returns in exchange for accepting the first loss in the cash flow distribution. In contrast, senior tranche holders receive payments first and are prioritized due to their lower risk and more secure position in the capital structure. Mezzanine tranche holders rank above equity holders but below senior tranches, and their cash flows are allocated after the senior holders. Underwriters, while playing a vital role in the issuing process, do not directly receive residual cash flows as part of this hierarchy. The essence of the waterfall structure is to balance risk and reward among different classes of investors according to their prices for risk.