Consider the following basic \(\$ 150\) million \(\mathrm{CDO}\) structure with the coupon rate to be offered at the time of issuance as shown:

Assume the following:
- The collateral consists of bonds that all mature in 10 years.
- The coupon rate for every bond is the 10-year Treasury rate plus 300 basis points.
- The collateral manager enters into an interest rate swap agreernent with another party with a notional amount of \(\$ 100\) million.
- In the interest rate swap the collateral manager agrees to pay a fixed rate each year equal to the 10-year Treasury rate plus 100 basis points and recive \(L J B O R\)

a. Why is an interest rate swap needed?

b. What is the potential return for the subordinate/ equity tranche, assuming no defaults?

c. Why will the actual return be less than the return computed?

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Tranche Senior Mezzanine Par Value $100,000,000 $ 30,000,000 Coupon Rate LIBOR + 50 basis points Treasury rate + 200 basis points Subordinated/ $ 20,000,000 None equity