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A bank is considering buying (i.e., selling protection on) an AAA-rated super senior tranche [10% - 11%] of a synthetic collateralized debt obligation (CDO) referencing an investment-grade portfolio. The pricing of the tranche assumes a fixed recovery of 40% for all names. All else being equal, which one of the following four changes will make the principal invested more risky?
A. An increase in subordination of 1%, i.e., investing in the [11% - 12%] tranche
B. An increase in the tranche thickness from 1% to 3%, i.e., investing in the [10% - 13%] tranche
C. Using a recovery rate assumption of 50%
D. An increase in default correlation between names in the portfolio
information on four investment proposals is given belowproposalinvestmentnet
What is the NPV of this investment if the cost of capital is 6%? Should the firm undertake the project? Repeat the analysis for discount rates of 2% and 12%.
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