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A CDO of $100 million notional value with five year maturity has the following structure Tranche Size(million) Spread(bps) O/C target I/C target A 60 50

A CDO of $100 million notional value with five year maturity has the following structure

Tranche Size(million) Spread(bps) O/C target I/C target

A 60 50 1.35 1.6

  1. B 10 200 1.25 1.4
  2. C 10 500 1.13 1.2

Equity 20

The CDO collateral has an average annual coupon rate of 10% payable semiannually. The CDO manager charges a deal structuring fee of 100 bps of the notional amount amortized over the life span of the CDO at 5% per annum. The yearly manager fee is 40 bps for the senior tranche and 20 bps for the subordinated tranches. The current risk free interest rate is 6% on a BEY basis.

(i) If there is no default, find the semiannual cash flow distributions to deal restructuring fees, asset manager fees, payments to tranches A, B, and C, and payment to equity tranche. Calculate the O/C and I/C ratios for tranches A, B, and C. Are these ratios above their target levels? (10 marks)

(ii) Assume the collateral portfolio loses $10 million before the first coupon payment date. Redo all of the calculations in part (4bi) above. Are the O/C and I/C ratios for tranches A, B, and C above their target levels? If not, how should we adjust? (10 marks)

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