uppose we collect a portfolio of 125 high coupon CDSs with equal notional. We
mean to issue a contract that covers the last 70% of possible loss on such
portfolio. The contract does not impose any negative cashflow to its holder as
long as less than 30% of the portfolio reported a credit event. If all the
CDSs are uncorrelated then the probability of loss on such contract is rather
slim. Hence, we offer a low coupon on it. The holder of such contract hardly
ever have to do anything but she earns a small coupon. Hence, the contract is
attractive. Such contract is called "the senior tranche of CDO".
We also mean to issue a contract that covers first 5% of the loss on the
portfolio. We call such a contract "the equity tranche". The probability of
loss on the equity tranche is significant. However, since we have a pool of
high coupon CDSs and we mean to pay only a small coupon to the senior tranche,
we are capable to reward any holder of the equity tranche with such a high
coupon that may not be found among securities of other types. Hence, the
equity tranche is attractive as well. Similarly, we assign some modest coupons
to contracts that cover 5%-30% of the possible losses. Such contracts are
called "mezzanine tranches".
The initial portfolio's risk exposure may be covered in such manner and
variety of securities for every risk appetite may be offered on the market.
Small part of coupon cashflow is diverted as management fee.