1. Suppose you own $ 1 million of securitized paper backed by interest payments on various sorts of consumer loans. There are 5 tranches ranging from AAA to CCC; for simplicity, assume that each tranche represents 20% of face value. Obviously, each tranche has an expected annual default rate built in. The expected default rates range from 1% to 5% by tranche. When you bought, the $1 million represented an expected yield to maturity of 5%.

a. Now suppose that as the economy enters recession, the default rate on the CCC tranche rises to 15%. If you had planned to hold the asset for another 5 years, at what price (approximately) would you be happy to sell it for now? Show your calculations and explain your reasoning.

b. Clearly, the market reaction in 2007-8 to a similar event was quite different. Why? Was that reaction justified?