Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Question
Transcribed Image Text:O. $122
O. $68
O. $60
0.$75
Transcribed Image Text:Suppose that the First United Bank of America has
two loans. Each is due to be repaid one period hence
and has independent and identically distributed cash
flows. Each loan will repay $300 with a probability of
0.8 and $150 with a probability of 0.2. However, while
the bank knows this, the investors cannot distinguish
this loan from that of the Third TransAmerica Bank,
which has the same number of loans, but will pay
$300 with a probability of 0.5 and $150 with a
probability of 0.5. There is a prior belief of 0.5 that the
First United Bank of America has the higher-valued
portfolio. Suppose that the First United wished to
securitize these loans, and if it does so without a
credit enhancement, the cost of communicating the
true value is 7.5% of the true value. Assume that the
discount rate is zero and that everybody is risk-
neutral. Consider the following securitization
scenario. The First United can create two classes of
bondholders in a senior- subordinated structure or
junior-senior structure. Class A bondholders will
receive the first tranche and are entitled to $300 in
aggregate. After they are paid off, class B bondholders
are entitled to receive $300 or the residual cash flow,
whichever is smaller. Suppose First United can find a
credit enhancer. With credit enhancement, class B
bondholders can be guaranteed to receive $300. The
market for credit enhancement is competitive.
Ignoring the possibility of default by the credit
enhancer, how much will the First United have to pay
the credit enhancer?
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