This is a multiple choice question. Thank you for your help. 13-14. Consider a C

Question

This is a multiple choice question. Thank you for your help.

13-14. Consider a CDO made up of three identical mortgages of $1,000.00. Assume that the probability of any mortgage defaulting is p, all defaults are independent, and that the recovery rate is zero. Call the first to default tranche of the CDO Li, the second L2, etc. L1 bears the first $1,000 of losses, L2 the next $1,000, etc. For a security to be considered AAA, the probability of a total loss has to be less than 3%. What is the highest value for p that would still make tranche L3 be rated AAA? (a) 3%; (b) 25%; (c) 21%; (d) 31%

Explanation / Answer

Since L1 L2 and L3 are identical it means they should all be AAA rated. For AAA rating max probability of default = 3%

Thus highest value of p is 3%.

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