You get a job in the mortgage-backed security department at Moodys, a rating agency. The model you
Question:
You get a job in the mortgage-backed security department at Moody’s, a rating agency. The model you are given states that mortgage defaults are independent events. You are asked to rate the following mortgage-backed security. The security is a single-class passthrough, and there are only two interest-only subprime mortgages of equal size in the pool. After servicing fees, each mortgage pays 10% interest. It is estimated that each mortgage has a 10% probability of defaulting at the end of the year. In the event of default, it is expected that 80% of the principal will be recovered.
Performing the computations assuming mortgage defaults are independent events. . . .
What is the probability both mortgages will default?
What is the expected return on the securities?
What is the variance of the return?
What is the probability investors will lose more than 10% of their principal?
You wonder what would happen in the extreme case in which outcomes were perfectly correlated, i.e., either both default or both pay in full.
What is the probability both mortgages will default?
What is the expected return on the securities?
What is the variance of the return?
What is the probability investors will lose more than 10% of their principal?
Under which scenario do the securities appear to be riskier? Briefly explain
International Economics
ISBN: 978-1429278447
3rd edition
Authors: Robert C. Feenstra, Alan M. Taylor