CAS Exam 9 Spring 2016, Question 18
Study guide: Exam 9
Given the following for a group of mortgages:
- Principal amounts are $1 million each.
- Probability of default is 5% for each mortgage.
- Defaults are uncorrelated.
- There are no recoveries on defaults.
Assume all CDOs and CDO^2s contain two underlying securities, and all securities have two tranches.
Part a (1.5 points)
Construct a synthetic security from the junior tranche of a CDO and the junior tranche of a CDO^2 with tranches of size $1 million and calculate the default probability of the senior tranche of the security.
Part b (0.5 points)
Explain how an increase in the correlation between the underlying mortgages should affect the rating agency's ratings for the senior tranche in part a. above.
Answer this question and see the worked solution