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Homework II

1) In the article “Credit Default Swaps and Structured Credit: A Primer for Wealth Managers” by Jeffrey T. Prince, CFA, he recognizes five problems that were associated with the collateral that was used to create ABS CDOs. (25 points)
a) Name and discuss briefly the five problems associated with the collapse in the ABS CDO market. Note the collapse was due to the very high default rates experienced by ABS CDOs. The five problems or issues are said to be the reason default rates were so high.
b) The article also briefly mentions two opposing views as to who, in general, was at fault for the bubble. Please list and briefly describe the two opposing views. Which viewpoint does the author agree with?
c) What was, or is, the “Anthos Funding” deal? Describe it in brief terms. What are its unique characteristics? Why is it mentioned in the article by Mr. Prince?

2) In class, we constructed a CDO utilizing three bonds. We saw that by utilizing “pooling”, and “prioritizing” default claims, we created securities with attractive characteristics. Essentially, we “re-packaged” existing debt that is “pari passu” into priority claims on the collateral of the pool. The result is, a portion of the issued debt has reduced probability of default and is of higher quality than the collateral of the pool – that securitizes the debt. (75 points)
a) Assume you purchase four bonds. Create a CDO and issue four tranches of bonds. Model the pool and display the probabilities of default, the pay-offs, and recovery rates. Calculate the current price of each bond and the YTM. Calculate the total market value of the pool.
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1) The collateral has a total value of 400 with 100 allocated to each bond
2) Bonds are risky, speculative grade bonds
3) Defaults are independent and occur only at maturity
4) At maturity, each bond pays 100
5) Each bond has a 15% probability of default
6) Each bond has a 30% recovery rate
7) Risk free rate is 5%
b) Issue four tranches of bonds, the size of each tranche will be as follows

1) Senior Tranche ?
2) Mezzanine Tranche ?
3) Subordinated Mezzanine Tranche ?
4) Subordinated Tranche ?

c) Calculate the price, YTM, default probability and recovery rates for each issue. Were you successful in creating a CDO with superior characteristics than the individual bonds?

d) Given, your answer to item C, make any changes you like to the size of the tranches to improve the characteristics of the bonds being issued.

e) Why do we assume defaults are independent?

The attached spreadsheet displays the format and necessary calculations. Please follow this format.
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