CAS Exam 9 Spring 2014, Question 16

Study guide: Exam 9

Consider three securities:

• A catastrophe bond.
• A junior tranche on a collateralized debt obligation (CDO).
• A senior tranche on a collateralized debt obligation squared (CDO^2).

Assume the following:

• The market estimates the same probability of default for the catastrophe bond as for the individual mortgages underlying the CDO and CDO^2.
• The market expects the same return on all three securities.

Part a (0.5 points)

Explain which of the three securities would be considered preferable according to the capital asset pricing model (CAPM).

Part b (1.5 points)

Assume that the probability of default on the underlying mortgages and the catastrophe bond increase by the same amount. Explain how an investor should rank the three securities from most to least preferable.

Part c (1.5 points)

Assume the correlation of defaults for the underlying mortgages moderately increases. Explain the impact on the market price for each of the three securities.

Answer this question and see the worked solution

Concepts tested

• Structured Finance
• CAT Bonds
• Securitization
• Correlation

More questions from this set

• CAS Exam 9 Spring 2014, Question 15
• CAS Exam 9 Spring 2014, Question 17