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.