Tranche Senior Mezzanine Subordinated/ equity Par Value $100,000,000 $ 30,000,000 $ 20,000,000 Coupon Rate LIBOR + 50 basis points Treasury rate + 200 basis points None

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Your Question:

Consider the following basic $150 million CDO structure with the coupon rate to be offered at the time of issuance as shown:

 

Assume the following:

  • The collateral consists of bonds that all mature in 10 years.
  • The coupon rate for every bond is the 10-year Treasury rate plus 300 basis points.
  • The collateral manager enters into an interest rate swap agreement with another party with a notional amount of $100 million.
  • In the interest rate swap the collateral manager agrees to pay a fixed rate each year equal to the 10-year Treasury rate plus 100 basis points and receive LIBOR.
  1. Why is an interest rate swap needed?
  2. What is the potential return for the subordinate/ equity tranche, assuming no defaults?
  3. Why will the actual return be less than the return computed?
Tranche
Senior
Mezzanine
Subordinated/
equity
Par Value
$100,000,000
$ 30,000,000
$ 20,000,000
Coupon Rate
LIBOR
+ 50 basis points
Treasury rate
+ 200 basis points
None
Transcribed Image Text:Tranche Senior Mezzanine Subordinated/ equity Par Value $100,000,000 $ 30,000,000 $ 20,000,000 Coupon Rate LIBOR + 50 basis points Treasury rate + 200 basis points None
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