How are CDOs structured regarding risk?

Collateralized Debt Obligations (CDOs) are structured into different tranches, which allows for a varied distribution of risk among the investors. Each tranche represents a different level of risk and return, with the senior tranches having a lower risk and lower return compared to the junior or equity tranches that take on more risk in exchange for potentially higher returns.

This structure means that in the event of defaults on the underlying assets—such as loans or bonds—senior tranche investors are paid back first, while investors in the junior tranches are at greater risk of losing their investment. This layering allows CDOs to appeal to a range of risk appetites in the market, enabling different investors to choose their preferred level of risk exposure.

In contrast, options suggesting that all tranches carry the same level of risk, that they are solely low-risk investments, or that they are guaranteed by the government do not accurately depict how CDOs function. The senior-junior tranche system is fundamental to CDOs, as it defines both their risk profile and their appeal to various types of investors.