In this project, you are given a portfolio of 10 identical bonds. Each bond has a face value of $10 MM, 6% coupon paid quarterly, and YTM 9%. The probability of default is 1% per quarter. The LGD is assumed to be 60%. In the event of default, we follow the Basel convention where each of the remaining scheduled payments is reduced to its recovery value, so that every scheduled payment of $1 (for example) becomes $0.40 if default occurs.

The correlation between each bond pairs default rate is 20%. The risk-free rate is 1% per year.

Part I

- Build a simulation model for the cash flows of the bonds.

Part II

- Design a simple CDO with a Class A tranche, Class B tranche and residual. The base case is to issue $40 MM Class A and 10 MM Class B, where A has a 2% coupon rate and B has a 4% coupon rate. Compute the scheduled cashflows to the three tranches, and then show the impact of default.

- Value the tranches using the CAPM version introduced in class. You must determine the cost of risk in order to complete this exercise.