CFA Practice Question

There are 490 practice questions for this study session.

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
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%

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
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