Homework 8

Homework 8 - two bonds defaulting together. We want to...

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Fin 448: Fixed-Income Securities Homework 8 Wei Yang Assigned: May 26 Due: June 2 If you submit early, I will send you the solution early Each problem counts as 10 points. 1 Default correlation and CDO In order for a CDO to produce a highly rated senior tranche, a low correlation between the defaults of the underlying bonds is much desired. Assume that we have access to a pool of bonds, from which we can pick two bonds to build a CDO. All the bonds pay a face value of $100 in a year, and the risk-neutral probability of default is 5% and the recovery rate is 50%. What differs among these bonds is the default correlation, or how large is the probability of
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Unformatted text preview: two bonds defaulting together. We want to construct a senior tranche with a face value of 140, and a target spread of 40 bp. For simplicity, assume the risk-free rate is 0, and thus the effective yield is also the spread. (1.1) If we choose two bonds with a 2% probability to default together, what is the resulting spread of the senior tranche? (1.2) In order to achieve the target spread of 40 bp for the senior tranche, how large is the probability for two bonds to default together? 1...
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This note was uploaded on 10/06/2011 for the course FIN 448 taught by Professor Weiyang during the Spring '10 term at Rochester.

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