How do CDS index tranches work and what risks do equity, mezzanine, and senior tranches carry?

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AcadiFi · Accepted Answer

CDS index tranches slice the default loss distribution of an index into layers, allowing investors to take targeted credit correlation exposure. Using CDX.NA.IG as example with $100M notional, standard tranche attachment/detachment points are: equity (0-3%), junior mezzanine (3-7%), senior mezzanine (7-15%), and super senior (15-100%). ```mermaid flowchart TB L[Portfolio
Losses] --> E[Equity
0-3%] L --> JM[Junior Mezz
3-7%] L --> SM[Senior Mezz
7-15%] L --> SS[Super Senior
15-100%] E -->|High Risk
High Spread| INV1[Hedge Funds] SS -->|Low Risk
Low Spread| INV2[Banks] ``` Equity tranche absorbs the first 3% of portfolio losses — if defaults with recovery of 40% cause cumulative losses of 2.5%, equity bears full loss. Equity investors earn the highest spread (often 500+ bps plus upfront) but face catastrophic risk. Mezzanine tranches only start losing after equity is wiped out. Super senior is highly rated (AAA-equivalent) and pays minimal spread. The key risk dimension is default correlation. Equity tranche is 'long correlation' — higher correlation means losses cluster in tail scenarios, reducing probability of small losses that hurt equity. Senior tranche is 'short correlation' — higher correlation increases tail-loss probability, hurting senior holders. This is why correlation trading exists: hedge funds go long equity / short mezzanine to bet on correlation changes. Tranches are priced using Gaussian copula models with a single correlation parameter. The 2007-2008 crisis revealed fundamental flaws when correlations spiked beyond model assumptions.

How do CDS index tranches work and what risks do equity, mezzanine, and senior tranches carry?

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