CovalJurek+StaffordExample

CovalJurek+StaffordExample - Lecture 5, ECON 220A, Fall...

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Lecture 5, ECON 220A, Fall 2011 Dale J. Poirier Coval, Jurek, and Stafford (2009, JEP ) The essence of structured finance activities is the pooling of economic assets like bonds, and the subsequent issuance of a prioritized capital structure of claims, known as tranches , against these collateral pools. C As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. C At the core of the 2008 financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.
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Lecture 5, ECON 220A, Fall 2011 Dale J. Poirier C The tranches are prioritized in how they absorb losses from the underlying portfolio. B Senior tranches only absorb losses after the junior tranche s claims have been exhausted. This allows senior tranches to obtain credit ratings in excess of the average rating on the average for the collateral pool as a whole. B The degree of protection offered by the junior claims, or over- collateralization , plays a crucial role in determining the credit rating for a more senior tranche, because it determines the largest portfolio loss that can be sustained before the senior claim is impaired.
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Lecture 5, ECON 220A, Fall 2011 Dale J. Poirier Example: Consider two identical bonds both of which have a probability of default p D = Prob(Y 1 = 1) = Prob(Y 2 = 1), and pay $0 conditional on default
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This note was uploaded on 12/13/2011 for the course ECON 220a taught by Professor Poirier,d during the Fall '08 term at UC Irvine.

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CovalJurek+StaffordExample - Lecture 5, ECON 220A, Fall...

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