ABC is setting up a CDO with four tranches to be backed by $300 million collateral investment consisting of fixed-rate, investment-grade bonds with a par value of $300 million, a weighted average maturity of 10 years, and yielding a return expected to pay 200 basis points over the 10-year T-notes. The CDO is to have four tranches:

 A senior A1 tranche with a par value of $150 million, paying a fixed rate equal to the 10-year T-note rate plus 150 basis points.

 A senior A2 tranche with a par value of $100 million and paying a floating rate equal to LIBOR plus 100 basis points.

 A subordinate B tranche with a par value of $20 million and paying a fixed rate equal to the 10-year T-note rate plus 200 basis points.

 A subordinate/equity tranche with a par value of $30 million that receives the excess return: return from collateral minus returns paid to the other tranches.

The managers will also enter a swap contract as a fixed-rate payer to fix the rate on Tranche A2.

Questions:

a. Suppose the manager enters an interest rate swap contract where the manager agrees to pay a fixed rate of 5% on a $100 million notional principal in return for the receipt of a floating rate payment equal to the LIBOR on a $100 million notional principal. Show in a table format how the interest rate swap, when combined with the floating rate loan obligation on Tranche A2, serves to fix the rate on the tranche at 6%.

b. If the manager expected the initial investment of collateral to be in investmentgrade bonds yielding 7% when Treasuries were yielding 5%, determine the expected first-year cash flows to the collateral, each tranche, the swaps, and the equity/subordinate class.