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You have been assigned to calculate how much money each Tranche will receive. There are 10 mortgages in a pool. Each mortgage has a value of $10,000,000 for a total pool of $100,000,000. Each mortgage is an interest only mortgage paying a 6% interest rate. Half of the mortgages will mature this year and half of them will mature next year. An A Tranche has been established with a par of $75,000,000 and a coupon of 4%. A B Tranche has been established with a par of $25,000,000 and a coupon of 6%. Finally, an Interest Only Tranche has also been established. 3 mortgages default after the first year. Investors will only recover half of the value of each of these 3 mortgages.
1. Calculate scheduled and received cash flows for each Tranche and the Pool as a whole for both years.
2. Explain why Tranche A has a lower coupon rate than Tranche B.
3. Explain how an Interest Only Tranche can be created and why this is the only bond in the world that's value goes down as interest rates go down.
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