9. (7 points) Consider a simple sequential Commercial Mortgage-Backed Securities
(CMBS) deal with the following senior/subordinated structure:
Class Rating Average Life Size
A-1 AAA 9.3 73.50
A-2 AA 10.0 5.50
A-3 A 10.0 6.00
B-1 BBB 10.0 4.75
B-2 BB 10.0 4.00
B-3 B 10.0 4.00
C Not Rated 10.0 2.25
Loan N/A 9.5 100.00
Collateral information:
Debt Service
Coverage
Ratio
(DSCR)
Loan-to-value
(LTV)
Net Operating
Income (NOI)
Volatility
Original 2.5 65% 6%
Stressed 1.2 90% 10%
•Collateral consists of 9% coupon, non-callable, 10-year balloon, commercial
mortgage loans with a 30-year amortization schedule.
•Subordinated class loss allocation: C, B-3, B-2, B-1, A-3, A-2.
(a) Describe how your Option Adjusted Spread (OAS) valuations would change by
rated class if the collateral weighted average DSCR and LTV ratios were to
change over the short term from original to stressed levels.
(b) Describe the relative impact of using the stressed NOI volatility assumption
versus the original assumption on your OAS valuations for the B classes.
COURSE 8: Investment - 10 - GO ON TO NEXT PAGE
November 2000
Afternoon Session
9. (Continued)
(c) Assume the following:
•The collateral is made up of lower quality commercial mortgage loans that
have prepayment penalties and are fully callable at par after five years without
penalty.
•The most senior class is priced at a discount.
Describe the impact of these assumptions on your OAS valuations for the most
senior class.
(d) (i) Explain the rationale for an issuer to use interest-only (IO) classes in a class
structure.
(ii) Describe the sensitivity of the OAS valuation of an IO class to default losses
and involuntary principal payments in a senior-subordinated CMBS deal.
COURSE 8: Investment - 11 - GO ON TO NEXT PAGE
November 2000
Afternoon Session
10. (7 points) You are the portfolio manager for a United Kingdom domiciled insurance
company. The portfolio currently has a U.S. asset of $300,000 with a volatility
(s) of 0.02 per day.
You have been asked to evaluate an investment in a Planned Amortization Class (PAC)
tranche of a collaterized mortgage obligation, where the mortgage collateral is residential
mortgages originated in the U.S. The PAC security you are considering is $200,000 and
has an asset volatility(s) of 0.015 per day.
The two assets have a correlation factor of 30%. The change in portfolio value is
normally distributed and asset returns have a bivariate normal distribution.
(a) Describe the factors affecting mortgage prepayment modeling.
(b) Describe, in general, the risks associated with political climate risk.
(c) Describe the three distinct categories of currency hedging techniques available for
hedging this asset.
(d) Assess the benefit of diversification when adding this PAC security to the
portfolio, using a 5-day, 95% VAR. Show your work.
COURSE 8: Investment - 12 - GO ON TO NEXT PAGE
November 2000
Afternoon Session
11. (6 points) Your company has a portfolio of investment-grade bonds and mortgagebacked
securities (MBS) with an option-adjusted duration of 4 years. The portfolio
supports a closed block of single premium deferred annuities (SPDAs) with minimum
rate guarantees of 5%.
The company, using the portfolio yield method, declares the crediting interest rates
monthly. However, the V.P. of marketing strongly recommends that the credited rate be
based on current market rates.
The company's economist has forecast the following interest rates under two economic
scenarios:
Current
Environment
Recession
Scenario
Inflation
Scenario
10 Year T-Note Yield 6% 4% 8%
90 Day T-Bill Yield 5% 3% 11%
(a) Predict the effects on your company's asset portfolio and the SPDA block using
each interest rate crediting methodologies under the following:
(i) recession scenario
(ii) inflation scenario
(b) Explain why it may be disadvantageous to reposition the portfolio using outright
sales and purchases.
(c) Describe option strategies to hedge against a movement from the current
environment to:
(i) recession scenario
(ii) inflation scenario
(d) Describe the risks related to the options strategies used in (c).
COURSE 8: Investment - 13 - GO ON TO NEXT PAGE
November 2000
Afternoon Session

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