Please go over the Homework problems as well!

Chapter 8

Problem 8.5.
What are the numbers in Table 8.1 for a loss rate of a) 12% and b) 15%?

Losses on Losses to Losses to Losses to Losses to senior

underlying mezzanine equity tranche mezzanine tranche tranche of ABS
assets tranche of ABS of ABS CDO of ABS CDO CDO
12% 46.7% 100% 100% 17.9%
15% 66.7% 100% 100% 48.7%

Problem 8.16.
Suppose that the principal assigned to the senior, mezzanine, and equity tranches is 70%, 20%,
and 10% for both the ABS and the ABS CDO in Figure 8.3. What difference does this make to
Table 8.1?

Losses to Losses to Mezz Losses to equity Losses to Mezz Losses to senior

subprime tranche of ABS tranche of ABS tranche of ABS tranche of ABS
portfolio CDO CDO CDO
10% 0% 0% 0% 0%
13% 15% 100% 25% 0%
17% 35% 100% 100% 7.1%
20% 50% 100% 100% 28.6%

Problem 8.18.
Suppose that mezzanine tranches of the ABS CDOs, similar to those in Figure 8.3, are
resecuritized to form what is referred to as a “CDO squared.” As in the case of tranches created
from ABSs in Figure 8.3, 65% of the principal is allocated to a AAA tranche, 25% to a BBB
tranche, and 10% to the equity tranche. How high does the loss percentage have to be on the
underlying assets for losses to be experienced by a AAA-rated tranche that is created in this way.
(Assume that every portfolio of assets that is used to create ABSs experiences the same loss rate.)

For losses to be experienced on the AAA rated tranche of the CDO squared the loss rate on the
mezzanine tranches of the ABS CDOs must be greater than 35%. This happens when the loss
rate on the mezzanine tranches of ABSs is 10+0.35×25 = 18.75%. This loss rate occurs when the
loss rate on the underlying assets is 5+0.1875×15 = 7.81%
Chapter 20

Problem 20.5.
Explain carefully why a distribution with a heavier left tail and less heavy right tail than the
lognormal distribution gives rise to a downward sloping volatility smile.

The heavier left tail should lead to high prices, and therefore high implied volatilities, for out-of-
the-money (low-strike-price) puts. Similarly the less heavy right tail should lead to low prices,
and therefore low volatilities for out-of-the-money (high-strike-price) calls. A volatility smile
where volatility is a decreasing function of strike price results.

Chapter 22

Problem 22.17.
Consider a position consisting of a $300,000 investment in gold and a $500,000 investment in
silver. Suppose that the daily volatilities of these two assets are 1.8% and 1.2% respectively, and
that the coefficient of correlation between their returns is 0.6. What is the 10-day 97.5% VaR
and ES for the portfolio? By how much does diversification reduce the VaR?

The variance of the portfolio (in thousands of dollars) is

00182  3002  00122  500 2  2  300  500  06  0018  0012  10404
The standard deviation is 10404  102 . Since N (196)  0025 , the 1-day 97.5% VaR is
102 196  1999 and the 10-day 97.5% VaR is 10 1999  6322 . The 10-day 97.5% VaR is
therefore $63,220. The 10-day 97.5% value at risk for the gold investment is
5 400  10  196  33 470 . The 10-day 97.5% value at risk for the silver investment is
6 000  10  196  37188 . The diversification benefit is
33 470  37 188  63 220  $7 438
The 10-day 97.5% ES is
2
10.2  10  e 1.96 /2
 75.4
2  0.025

Chapter 23

Problem 23.2.
What is the difference between the exponentially weighted moving average model and the
GARCH(1,1) model for updating volatilities?

The EWMA model produces a forecast of the daily variance rate for day n which is a weighted
average of (i) the forecast for day n  1 , and (ii) the square of the proportional change on day
n  1 . The GARCH (1,1) model produces a forecast of the daily variance for day n which is a
weighted average of (i) the forecast for day n  1 , (ii) the square of the proportional change on
day n  1 . and (iii) a long run average variance rate. GARCH (1,1) adapts the EWMA model by
giving some weight to a long run average variance rate. Whereas the EWMA has no mean
reversion, GARCH (1,1) is consistent with a mean-reverting variance rate model.

Problem 23.9.
Suppose that the daily volatilities of asset A and asset B calculated at the close of trading
yesterday are 1.6% and 2.5%, respectively. The prices of the assets at close of trading yesterday
were $20 and $40 and the estimate of the coefficient of correlation between the returns on the
two assets was 0.25. The parameter  used in the EWMA model is 0.95.
(a) Calculate the current estimate of the covariance between the assets.
(b) On the assumption that the prices of the assets at close of trading today are $20.5 and $40.5,
update the correlation estimate.

(a) The volatilities and correlation imply that the current estimate of the covariance is
025  0016  0025  00001 .
(b) If the prices of the assets at close of trading are $20.5 and $40.5, the proportional changes
are 05  20  0025 and 05  40  00125 . The new covariance estimate is
095  00001  005  0025  00125  00001106
The new variance estimate for asset A is
095  0016 2  005  00252  000027445
so that the new volatility is 0.0166. The new variance estimate for asset B is
095  00252  005  001252  0000601562
so that the new volatility is 0.0245. The new correlation estimate is
00001106
 0272
00166  00245

Problem 23.17.
Suppose that the price of gold at close of trading yesterday was $600 and its volatility was
estimated as 1.3% per day. The price at the close of trading today is $596. Update the volatility
estimate using
(a) The EWMA model with   094
(b) The GARCH(1,1) model with   0000002 ,   004 , and   094 .

The proportional change in the price of gold is 4  600  000667 . Using the EWMA model
the variance is updated to
094  00132  006  000667 2  000016153
so that the new daily volatility is 000016153  001271 or 1.271% per day. Using GARCH
(1,1) the variance is updated to
0000002  094  00132  004  000667 2  000016264
so that the new daily volatility is 000016264  01275 or 1.275% per day.
Chapter 24

Problem 24.13.
A company has issued 3- and 5-year bonds with a coupon of 4% per annum payable annually.
The yields on the bonds (expressed with continuous compounding) are 4.5% and 4.75%,
respectively. Risk-free rates are 3.5% with continuous compounding for all maturities. The
recovery rate is 40%. Defaults can take place half way through each year. The risk-neutral
default rates per year are Q1 for years 1 to 3 and Q2 for years 4 and 5. Estimate Q1 and Q2 .

The table for the first bond is

Time Def. Recovery Risk-free Loss Given Discount PV of

(yrs) Prob. Amount Value ($) Default ($) Factor Expected
($) Loss ($)

0.5 Q1 40 103.01 63.01 0.9827 6192Q1

1.5 Q1 40 102.61 62.61 0.9489 5941Q1

2.5 Q1 40 102.20 62.20 0.9162 5698Q1

Total 17831Q1

The market price of the bond is 98.35 and the risk-free value is 101.23. It follows that Q1 is
given by
17831Q1  10123  9835

so that Q1  00161 .
The table for the second bond is

Time Def. Recovery Risk-free Loss Discount PV of Expected

(yrs) Prob. Amount Value ($) Given Factor Loss ($)
($) Default
($)
0.5 Q1 40 103.77 63.77 0.9827 6267Q1

1.5 Q1 40 103.40 63.40 0.9489 6016Q1

2.5 Q1 40 103.01 63.01 0.9162 5773Q1

 3.5 Q2 40 102.61 62.61 0.8847 5539Q2

4.5 Q2 40 102.20 62.20 0.8543 5313Q2

Total 18056Q1  10853Q2

The market price of the bond is 96.24 is and the risk-free value is 101.97. It follows that

18056Q1  10853Q2  10197  9624

From which we get Q2  00260 The bond prices therefore imply a probability of default of
1.61% per year for the first three years and 2.60% for the next two years.

Chapter 25

Problem 25.2.
A five-year credit default swap requires quarterly payments at the rate of 60 basis points per
year. The principal is $300 million and the credit default swap is settled in cash. A default
occurs after four years and two months, and the price of the cheapest deliverable bond is
estimated as 40% of its face value. List the cash flows and their timing for the seller of the credit
default swap.

The seller receives 300,000,000×0.0060×0.25 = $450,000 at times 0.25, 0.50, 0.75, 1.00,…. 4.0
years. The seller also receives a final accrual payment of about $300,000 (
 $300 000 000  0060  2  12 ) at the time of the default (4 years and two months). The seller
pays
300 000 000  06  $180 000 000
at the time of the default. (This does not consider day count conventions.)

Problem 25.8.
Suppose that the risk-free zero curve is flat at 7% per annum with continuous compounding and
that defaults can occur half way through each year in a new five-year credit default swap.
Suppose that the recovery rate is 30% and the hazard rate is 3%. Estimate the credit default
swap spread. Assume payments are made annually.

The table corresponding to Tables 25.1, giving unconditional default probabilities, is

Time (years) Probability of Default Probability

surviving to year end during year
1 0.9704 0.0296
 2 0.9418 0.0287
3 0.9139 0.0278
4 0.8869 0.0270
5 0.8607 0.0262

The table corresponding to Table 25.2, giving the present value of the expected regular payments
(payment rate is s per year), is

Time (yrs) Probability of Expected Discount Factor PV of Expected

survival Payment Payment
1 0.9704 0.9704s 0.9324 0.9048s
2 0.9418 0.9418s 0.8694 0.8187s
3 0.9139 0.9139s 0.8106 0.7408s
4 0.8869 0.8869s 0.7558 0.6703s
5 0.8607 0.8607s 0.7047 0.6065s
Total 3.7412s

The table corresponding to Table 25.3, giving the present value of the expected payoffs (notional
principal =$1), is

Time (yrs) Probability of Recovery Expected Discount PV of

default Rate Payoff Factor Expected
Payment
0.5 0.0296 0.3 0.0207 0.9656 0.0200
1.5 0.0287 0.3 0.0201 0.9003 0.0181
2.5 0.0278 0.3 0.0195 0.8395 0.0164
3.5 0.0270 0.3 0.0189 0.7827 0.0148
4.5 0.0262 0.3 0.0183 0.7298 0.0134
Total 0.0826

The table corresponding to Table 25.4, giving the present value of accrual payments, is

Time (yrs) Probability of Expected Accrual Discount PV of Expected

default Payment Factor Accrual Payment
0.5 0.0296 0.0148s 0.9656 0.0143s
1.5 0.0287 0.0143s 0.9003 0.0129s
2.5 0.0278 0.0139s 0.8395 0.0117s
3.5 0.0270 0.0135s 0.7827 0.0106s
4.5 0.0262 0.0131s 0.7298 0.0096s
Total 0.0590s

The credit default swap spread s is given by:

 3.7412s+0.0590s = 0.0826

It is 0.0217 or 217 basis points.

Problem 25.24.
Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and
that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year
plain vanilla credit default swap with semiannual payments. Suppose that the recovery rate is
20% and the unconditional probabilities of default (as seen at time zero) are 1% at times 0.25
years and 0.75 years, and 1.5% at times 1.25 years and1.75 years. What is the credit default
swap spread? What would the credit default spread be if the instrument were a binary credit
default swap?

The table corresponding to Table 25.2, giving the present value of the expected regular payments
(payment rate is s per year), is

Time (yrs) Probability of Expected Discount Factor PV of Expected

survival Payment Payment
0.5 0.990 0.4950s 0.9704 0.4804s
1.0 0.980 0.4900s 0.9418 0.4615s
1.5 0.965 0.4825s 0.9139 0.4410s
2.0 0.950 0.4750s 0.8869 0.4213s
Total 1.8041s

The table corresponding to Table 25.3, giving the present value of the expected payoffs (notional
principal =$1), is

Time (yrs) Probability of Recovery Expected Discount PV of

default Rate Payoff Factor Expected
Payment
0.25 0.010 0.2 0.008 0.9851 0.0079
0.75 0.010 0.2 0.008 0.9560 0.0076
1.25 0.015 0.2 0.012 0.9277 0.0111
1.75 0.015 0.2 0.012 0.9003 0.0108
Total 0.0375

The table corresponding to Table 25.4, giving the present value of accrual payments, is

Time (yrs) Probability of Expected Accrual Discount PV of Expected

default Payment Factor Accrual Payment
 0.25 0.010 0.0025s 0.9851 0.0025s
0.75 0.010 0.0025s 0.9560 0.0024s
1.25 0.015 0.00375s 0.9277 0.0035s
1.75 0.015 0.00375s 0.9003 0.0034s
Total 0.0117s

The credit default swap spread s is given by:

1804s  00117 s  00375
It is 0.0206 or 206 basis points. For a binary credit default swap we set the recovery rate equal to
zero in the second table to get the present value of expected payoffs equal to 0.0468 so that
1804s  00117 s  00468
and the spread is 0.0258 or 258 basis points.