A financial institution buys a $1 million bond issued by a large manufacturing company. The financial institution wants to protect itself from credit risk and pays a counterparty $1,000 annually in return for a promise from the counterparty to pay the financial institution the cash value of the loss from the credit event. As it turns out, trouble in the manufacturing industry causes a credit rating agency to lower the rating of the bonds after two years. As a result, the market value of the bonds falls by $12,000, and the financial institution decides to exercise its CDS on the bonds. In this case, how much is the the notional principal, or notional amount, of the derivative contract?

11. Note the following tranche schedule for this CDO.

	Amount ($millions)	YTM	Term (Mos)	Rating	CDS Enhanced
Tranche A	$15	1.98%	30	AAA	no
Tranche B	$85	2.75%	60	AA-	no
Tranche C	$250	3.05%	120	AA-	no
Tranche D	$250	4.87%	240	A	yes
Tranche Z	$50	6.12%	360	A	yes

Based on the above information, which tranche has the highest likelihood of the occurrence of a credit event? Explain.                  

Answer rating: 100% (QA)

A Credit Default Swap CDS is a type of derivative contract that provides protection against credit r... View the full answer