How do CDS index tranches work and what risk do they isolate?

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AcadiFi · Accepted Answer

CDS index tranches slice the default risk of a credit index (like CDX or iTraxx) into layers that absorb losses sequentially. Each tranche has an attachment point (where losses begin to hit) and a detachment point (where losses are fully absorbed). **Standard CDX IG tranches:** | Tranche | Attachment | Detachment | Absorbs Losses From | |---|---|---|---| | Equity | 0% | 3% | First 3% of portfolio losses | | Junior Mezzanine | 3% | 7% | Losses between 3-7% | | Senior Mezzanine | 7% | 15% | Losses between 7-15% | | Senior | 15% | 30% | Losses between 15-30% | | Super Senior | 30% | 100% | Losses above 30% | **Example -- CDX IG 125-name index, $10 billion notional (fictional scenario):** If 5 names default with 60% loss severity, total loss = 5 x ($80M notional each) x 60% = $240M = 2.4% of portfolio. - Equity tranche: Absorbs entire $240M loss (within 0-3% range) - All other tranches: Zero loss If 15 names default: Total loss = 15 x $80M x 60% = $720M = 7.2% - Equity tranche: Wiped out ($300M loss, the full 0-3%) - Junior Mezz: Absorbs $400M (the 3-7% layer) - Senior Mezz: Absorbs $20M (the first 0.2% of the 7-15% layer) \`\`\`mermaid flowchart TD A[Portfolio Losses Occur] --> B{Loss < 3%?} B -->|Yes| C[Equity Tranche Absorbs All] B -->|No| D{Loss < 7%?} D -->|Yes| E[Equity Wiped Out + Junior Mezz Absorbs Remainder] D -->|No| F{Loss < 15%?} F -->|Yes| G[Equity + Jr Mezz Wiped Out + Sr Mezz Absorbs] F -->|No| H[Losses Continue Up the Capital Structure] \`\`\` **Key insight:** The equity tranche buyer is taking a leveraged bet on default rates. A small change in expected defaults has a huge impact on equity tranche value. Conversely, the super senior tranche is only at risk in catastrophic systemic events. Tranche pricing depends heavily on **default correlation** -- the tendency for defaults to cluster together.

How do CDS index tranches work and what risk do they isolate?

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