A bank issues two mortgages M1 and M2 for $1 million each. Both mortgages mature at the end of the year with principle repayment equal to $1 million. M1 has an interest rate of 15% while M2 has an interest rate of 5% and both only pay a single interest payment at maturity. Both borrowers repay full principle plus interest at the end of the year in normal times (probability .95) but default in a recession (probability .05). M1's liquidation value in a recession is $500,000 while M2's liquidation value in a recession is $700,000. 

The bank creates a mortgage backed security from M1 and M2 which has only two tranches: a senior tranche which has an expected return of 4% and a junior tranche which has an expected return of 13.7%. The MBS pays out all proceeds from the mortgage repayments to the two tranches in each state of the world (i.e. the senior and junior tranche holders are the only stakeholders in the MBS). The senior tranche has priority to be repaid over the junior tranche. 

What is the market value of the senior and junior tranches at the time that they are issued? 

Answer rating: 100% (QA)

SOLUTION To determine the market value of the senior and junior tranches of the mortgage backed security MBS we need to calculate the expected cash flows for each tranche under normal and recession sc... View the full answer