Consider the following basic $150 million CDO structure with the coupon rate to be offered at the time of issuance as shown:
Tranche Coupon Par Value Coupon Rate
Senior $100,000,000 LIBOR + 50 basis points
Mezzanine $ 30,000,000 Treasury rate + 200 basis points
Subordinated/Equity $ 20,000,000
Assume the following:
• The collateral consists of bonds that all mature in 10 years.
• The coupon rate for every bond is the 10-Treasury rate plus 300 basis points.
• The collateral manager enters into an interest-rate swap agreement with another party with a notional amount of $100 million.
• In the interest-rate swap the collateral manager agrees to pay a fixed rate each year equal to the 10-year Treasury rate plus 100 basis points and receive LIBOR.
(a) Why is an interest-rate swap needed?
(b) What is the potential return for the subordinated/equity tranche assuming no defaults?
© Why will the actual return be less than the return computed?