You are a fixed income risk manager at a bank performing a scenario analysis. Your bank’s portfolio consists of 50% corporate bonds and 50% subprime mortgage-backed securities (MBS). You forecast the distributions of returns on these portfolios as described in the table below:

		Corporate bond portfolio	Subprime MBS portfolio
Scenario	Prob.	Return (%)	Return (%)
Severe recession	10%	-15%	-20%
Mild recession	20%	12%	6%
Normal growth	40%	10%	15%
Boom	30%	1%	10%

1. Due to regulatory requirements, your fixed income portfolio is not supposed to have losses of more than 15% or more with 10% or greater probability. Based on your forecasts, do you currently satisfy this requirement with your current portfolio? (Hint: no calculation is necessary)

2. Senior management is pressuring you to allow for more investment in subprime MBS, which have recently been highly profitable (and good for their bonuses). You counter that subprime MBS are too risky given your bank’s risk constraint. They argue that your portfolio is well-diversified given that it contains both corporate and mortgage-backed bonds and therefore it is not that risky to add more MBS.

1. Compute the correlation between the Corporate bond portfolio and the Subprime MBS portfolio.
2. Does this correlation suggest that the corporate bonds are a “good diversifier” for subprime MBS?s