5.Suppose that the three bonds are correlated in the following manner. Bond 1 and Bond 2 arecorrelated such that, if Bond 1 defaults, the probability of Bond 2 defaulting is 0.7. However, if Bond 1 does not default, the probability of Bond 2 not defaulting is also 0.9. Bond 3 is uncorrelated with Bonds 1 and 2. Redo your calculations for questions 1 to 4 above.

6.Go back to the zero correlation case. Suppose a CDS contract is available on one of the issuer of one of the three bonds, Bond 1. Suppose the price of the CDS is 350 basis points per year for seven years, payable on a compounded basis at the end of the seven years. What is the maximum size of the AAA tranche now, if this one-third of the total portfolio is fully protected against default? (You can assume that there is no counter-party risk in the CDS contract.)

7.Discuss, without calculations, how your answer might change if the credit rating agency used the expected loss percentage rather than the probability of loss as the criterion for the AAA rating.