1. 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. . . .

   1. What is the probability both mortgages will default?

   2. What is the expected return on the securities?

   3. What is the variance of the return?

   4. 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.

5. What is the probability both mortgages will default?

6. What is the expected return on the securities?

7. What is the variance of the return?

8. What is the probability investors will lose more than 10% of their principal?

9. Under which scenario do the securities appear to be riskier? Briefly explain

Answer rating: 100% (QA)

To perform the computations lets consider the given information and calculate the required probabilities and measures Assuming mortgage defaults are i... View the full answer