Hi, I have a few questions to ask:
1.Consider the cash flow pattern of the CDS in Exhibit 2. One way to think about a credit default swap is that its cash flows can be replicated with long and short positions in actual bonds. Specifically, from the protection of the credit-protection BUYER, the cash flows from a CDS equivalent to buying a risk-free floating rate bond and short selling the risky floating rate bond.
Explain/show why this replication strategy works using a numerical example. You should assume that the default-risk-free rate is 3 month Libor, and the risky floating rate is 3 month Libor + a credit spread. If you assign numerical values to these rates and the spread, assume that the bond matures in 1 year and therefore, assume that the swap that is being replicated would have a term of 1 year, assume that interest is paid every 3 months on each of the bonds, and finally assume that the bond's par value is $100, you can map out the cash flows of this strategy under two scenarios: first, if there is default just before maturity (at the end of year 1), and second, in the case with no default.
2. Given your example in #1, what is the cost of the credit default swap to the buyer (I want a rate here).
3. This question generally focuses on the tranching process and the role of the super-senior counterparty.
a. How did the BISTRO deal work?
b. How can AAA tranches be created from a pool of assets that is rated BBB?
c. What are super-senior tranches and what is their purpose?
4. Assume that a BBB MBS tranche is securitized into a CDO, with a super-senior tranche that covers say 70% of the total assets in the BBB tranche. Comment on the impact that correlation in the underlying loans in the BBB tranche can have on the value of the super-senior tranche during a financial crisis?
5. Assume that the loans in a BBB tranche of an MBS with $100MM in assets that is securitized into a CDO are perfectly correlated, that they cover 5% of the total assets of the MBS as in #5 above (so that equity covers the first $5 million and the BBB tranche covers the next $5 million) and that the defaults in the underlying MBS amount to $8 million. Assume that the super senior tranche of the CDO covers 70% of the total tranche. Assume also that in the CDO there is an AAA tranche covering 10% of the CDO, a BBB tranche covering 10% and an equity tranche covering 10%.
Answer the following questions about the CDO
- What will be the dollar loss to the equity tranche of the CDO?
- What will be the dollar loss to the BBB tranche of the CDO?
- What will be the dollar loss to the AAA tranche of the CDO?
- What will be the dollar loss to the super-senior tranche of the CDO?
6. Given your answers to question 5, do you think that super-senior tranche of a CDO is safer than a corporate bond with an AAA rating? Why or why not?
7. Generally, correlations among defaults tend to rise when markets are crashing. Is this good news or bad news for CDO investors?
8. Given all this analysis, do you think that Goldman made the right call in asking AIG for more collateral on the super senior tranches? Discuss.