Suppose That ABSs Are Created from Portfolios of Subprime Mortgages

question 18

Multiple Choice

Suppose that ABSs are created from portfolios of subprime mortgages with the following allocation of the principal to tranches: senior 94.5% (rated AAA) , mezzanine 0.1% (rated BBB) , and equity 5% (rated C) . The portfolios of subprime mortgages have the same default rates. An ABS CDO is then created from the mezzanine tranches. Which of the following is true?

• A) The ABS CDO tranches should have similar ratings ranging from AAA to C
• B) The ABS CDO tranches should all be rated BBB
• C) The ABS CDO tranches should all be rated C
• D) The ABS CDO tranches are almost worthless because the mezzanine tranches are so thin

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Definitions:

Dividend Yield

Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.

Capital Gains Yield

The percentage increase in the market price of an asset over time, excluding dividends.

Annual Dividend

The total dividend payments issued to shareholders by a company in a year.

Risk Premium

The return in excess of the risk-free rate of return that an investment is expected to yield, compensating investors for taking on additional risk.