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?

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

Netting the interest payments paid and received: $10 - 4.9 + $70 x LIBOR - $70 x LIBOR - 0.7 - $2 = $2.4 million

Return on investment = 2.4/10 = 24%