Explain how you would expect the returns offered

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Reference no: EM131240193

1. Assume that the default probability for a company in a year, conditional on no earlier defaults is λ and the recovery rate is R. The risk-free interest rate is 5% per annum. Default always occurs halfway through a year. The spread for a 5-year plain vanilla CDS where payments are made annually is 120 basis points and the spread for a 5-year binary CDS where payments are made annually is 160 basis points. Estimate R and λ.

2. Explain how you would expect the returns offered on the various tranches in a synthetic CDO to change when the correlation between the bonds in the portfolio increases.

Reference no: EM131240193

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