Reference no: EM133058362

Submit your spreadsheet work (along with this summary answer sheet) for the problems below:

(a) Consider the iTraxx Europe 5-year index (newly constituted). With quarterly payments and a quoted CDS spread on the index of 24 bps, find the corresponding constant conditional default probability (conditional on no default in earlier periods) expressed as a default intensity. Assume a 40% recovery rate and that the term structure of risk free rates is flat at 3.5%. (Hint: Refer to the technique used in the spreadsheet for Example 25.2 - we are looking for the same default probability here, but with quarterly periods - to facilitate the process described in Section 25.2. Consider reconstructing Hull's result for Example 25.2 as a check.)

(b) Price the equity tranche of the iTraxx Europe 5-year index - again with the assumptions stated above (and use your result from (a) for the constant hazard rate in equation (25.6), as in Example 25.2) - but also assume a copula correlation of 0.15. Use an M=60 Gaussian quadrature to find the unconditional values necessary to determine the solution.

(c) If the quoted price on the equity tranche was 11.25%, what is the implied compound correlation and what is the implied base correlation.