Tranches

Tranches are divisions of mortgage bonds in which the mortgage bonds are divided into pieces. The lower tranches consist of mortgages that are more than likely to be defaulted upon or paid off early and include a higher interest rate. The higher the tranches are, however, the less likely the borrower will default and the lower the interest rate, with the highest tranche consisting of mortgages that will more than likely mature as expected.

CDS

CDS (credit default swaps) is like insurance on a bond that pays out only if the borrower defaults on his loan. For example, in the subprime mortgage bonds an investor could buy a CDS for a low tranche on a mortgage bond and pay premiums semiannually. If the mortgage borrowers whose mortgages are held by that bond pay their mortgages as expected, the investor only loses the premiums. However, if the mortgage...