QUESTION 5
(a) Consider a Collateralized Debt Obligation where the reference portfolio
consists of $100 million worth of loans, that on average, yield 8%.
A CDO is created where: (i) the Senior Tranche is worth $65 million and with a coupon
rate of 5%; (ii) the Mezzanine Tranche is worth $30 million and with a coupon rate of 7.2%
and an equity tranche worth $5 million.
If the default rate in the reference portfolio is 1%, calculate the rate of return to: (i) the
Senior Tranche; (ii) the Mezzanine Tranche and (iii) the Equity Tranche. Assume that if
any loans in the reference portfolio default, then the full amount of the loan is lost and no
interest payments on these loans are received.
(b) Repeat your calculation in (a) above, but this time assume the default rate
in the reference portfolio is 9%. Again assume that if any loans in the reference portfolio
default, then the full amount of the loan is lost and no interest payments on these loans
are received.
