This is a group assignment. One copy can be turned in for a team of up to four students.
Assignment 7: Household Debt Products
The Readings section includes four readings on Collateralized Debt Obligations. They are complimentary to the talk by our guest speaker, Joe Naggar, but you do not need to read them all. Use the CLO Assignment Sheet (XLSX) to fill in your answers.
Complete the following tasks:
1. Design a simple 1 period model of a CLO with the following attributes:
| Assets (Loans) | Liabilities and Equity | |||
|---|---|---|---|---|
| Par | 500 | Par | Coupon | |
| Coupon | 6% | AAA | 325 | 2.00% |
| Default Rate | 0% | Mezzanine | 125 | 5.00% |
| Recovery Rate | 70% | Equity | 20 | IRR |
| Management Fees and Expenses | 1% | |||
Solve for the Asset Return, Debt Return and Equity Return.
2. Using your simple 1 period model, solve for the expected return of the equity using the following assumptions:
- The portfolio contains 20 assets (loans) of equal weight
- Each loan has a probability of default of 5%
- Each loan has a recovery rate of 70%
- Each asset is identically and independently distributed
3. What return on the assets is needed to generate a positive return on the Equity? What return on the assets would completely wipe out the Equity? (Equity gets no cash flow paid to it). Describe the Equity in the form of an option on the asset return.