- CFA Exams
- CFA Level I Exam
- Study Session 14. Fixed Income (1)
- Reading 45. Introduction to Asset-Backed Securities
- Subject 8. Collateralized Debt Obligations

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**CFA Practice Question**

Consider the following CDO transaction:

- The CDO is a $100 million structure.
- The collateral consists of bonds that all mature in five years. The coupon rate of these bonds is the five-year T-bond rate plus 400 basis points.
- The senior tranche is 70% of the deal. It pays a floating rate of LIBOR + 100 basis points.
- There is only one junior tranche of $20 million with a coupon rate of the five-year T-bond rate + 400 basis points.
- The asset manager enters into a swap in which it pays a fixed rate equal to the five-year T-bond rate + 100 basis points and receives LIBOR. The notional amount of the swap is $70 million.
- Assume that there is no default or asset management fee. All payments are made annually each year for simplicity.

If the five-year T-rate at the time the CDO is issued is 6%, what is the expected return on investment for the equity tranche?

A. 20%

B. 24%

C. 28%

**Explanation:**The equity tranche is $100 - $100 x 0.7 - 20 = $10 million

Each year:

- The collateral will pay interest of $100 x (6% + 4%) = $10 million to the CDO.
- The CDO pays $70 x (6% + 1%) = $4.9 million to the counterparty of the swap, and receives $70 x LIBOR.
- Interest to senior tranche: $70 x (LIBOR + 1%)
- Interest to junior tranche: $20 x (6% + 4%) = $2

Return on investment = 2.4/10 = 24%

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**User Contributed Comments**
4

User |
Comment |
---|---|

MSRus |
what is 0,7? from what source it's comming? |

Allen88 |
Where it says: Interest to senior tranche, the $70 is multiplied to 1% to get 0.7. |

Paulvw |
Must remember to include swap cash flows! |

milica818 |
Can someone please explain where the - 0.7m is coming from when netting interest received/paid? I don't get it |