CAS Exam 9 Spring 2018, Question 12
Study guide: Exam 9
An investor is considering investing in the senior tranche of a Collateralized Debt Obligation Squared (CDO^2) composed of the junior tranches of two Collateralized Debt Obligations (CDOs).
Given the following:
- CDOs are composed of two 1-year securities, which pay $100 at maturity and $0 at default.
- Each CDO and CDO
^2is constructed with a junior and senior tranche of width $100. - The probability of either security defaulting is 15%.
- The discount rate is 5%.
Part a (0.75 points)
Calculate the price of the senior tranche of the CDO^2 assuming defaults of the underlying securities are uncorrelated.
Part b (0.5 points)
Calculate the price of the senior tranche of the CDO^2 assuming defaults of the underlying securities are perfectly correlated.
Part c (0.75 points)
A rating agency uses default probabilities to assign ratings to these securities. Describe whether the expected return of these securities should be higher or lower than the expected return of single-name securities with the same rating.
Answer this question and see the worked solution