CAS Exam 9 Spring 2013, Question 12
Study guide: Exam 9
Suppose that three identical bonds are pooled and tranched to create a collateralized debt obligation (CDO). Each bond has the following characteristics:
- The probability of default is 5%.
- Each bond will pay $0 in the event of a default and $1 million otherwise.
The CDO is structured as follows:
- The first (or junior) tranche bears the first $1 million of loss.
- The second (or mezzanine) tranche bears the second $1 million of loss.
- The third (or senior) tranche bears loss only after the other two tranches have been exhausted.
Part a (1 point)
Calculate the difference between default probabilities for the mezzanine tranche assuming bond defaults are perfectly correlated versus completely uncorrelated.
Part b (1 point)
Explain how underestimating default probabilities for senior tranches of collateralized debt obligations led to the rise and fall of structured finance.
Answer this question and see the worked solution