Coval

Question 1

Why senior tranche riskier than single bond
(with similar risk of default)

Answer 1

1. Correlation: Higher prob of default
2. Systemic Risk: Higher risk premium
3. More sensitive to small errors in estimation

Question 2

Collateralized Debt Obligations

Answer 2

Pool fixed-income assets and prioritize payments into tranches

Converts underlying assets with high credit risk into a highly-rated investments for senior tranche

Question 3

Cons of CDOs

Answer 3

Extremely sensitive to assumptions (prob of default, correlation)
More exposed to systematic risk

Question 4

CDO-Squared

Answer 4

Underlying pool of assets might be tranche from one CDO and tranche from a second

Question 5

Great Recession Cause

Answer 5

CMOs (like CDO-Squared) prevalent

-Correlation higher than expected (geo, home age)
-Prob of default higher than expected (worsening credit)
-Asset recovery lower than expected (sold at low prices)

All magnified by CMOs

Question 6

Systematic Risk

Answer 6

Whether more likely to default in economic downturn

Two securities with same credit rating can have different risk here

Does impact yield spread though