Determine the market value of the 10-year risky debt

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Reference no: EM131540629

Question: Collateralized Debt Obligations

Nopay Bank is going to issue collateralized debt obligations (CDOs) against the entire issue of the 10-year risky debt of Fortune Limited as presented here:

Fortune Limited
Market Value of Assets		Market Value of Debt and Equity
Assets	$100	10-yr Debt (Face = $66.8)	??
		Equity	??

The risky debt is a zero-coupon bond that pays no interest. At maturity, the bond will pay the investors just the face value.

The underlying assets of Fortune Limited are valued at $100 today. The volatility of asset value in terms of annualized standard deviation is estimated to be 25%. The risk free rate of interest is 5% per year compounded continuously.

The entire issue of the 10-year risky debt with face value equal to $66.8 is to be placed into a debt pool. Against the debt pool, Nopay Bank will issue 10-year CDO with face value equal to $50 that pays no interest. The rest of the 10-year risky debt will be held in the debt pool as over-collateralization (equity).

(a) Determine the market value of the 10-year risky debt.

(b) Determine the market value of Fortune's equity.

(d) Determine the market value of the over-collateralization.

(e) Determine the cost of insurance to protect the CDO investors against Fortune's default.

(f) Determine the market value of Fortune's equity and the market value of the over-collateralization (equity of the debt pool) when the volatility of the asset value increases from 25% to 50%. Explain your findings with the results of part (b) and part (d) above.

Reference no: EM131540629

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