Exotic Options, Derivatives and Structured Products:

Nexgen Case - CDO Structuring

Waleed Alhaddad 57189351-5, Guy Bettschart 3218B904-7, Iliyas Kurmangali 57171501-5,
Utpakkumar Pankania 57189064-4

In this case, we structure a CDO to be issued by an SPV set up by Nexgen to meet ABC’s
client’s needs. Specifically, the objective is to create an AAA grade tranche for the client. The
residual tranche would be held by Nexgen. The universe of available bonds is Nexgen’s bond
portfolio.

Several key points are unknown ex-ante:

- The client’s required rate of return on the AAA tranche

- Nexgen’s acceptable risk-return profile on the residual tranche

We make the following assumptions, which will act as boundaries to the CDO structuring
problem:

- The client’s risk requirement of AAA is equivalent the 5 year AAA default rate (0.003)
- Bond defaults are independent
- For reasons of computing power, the CDO will have only 20 bonds as collateral

From Nexgen’s point of view, the objective is to maximize returns. In order to minimize risk for
Nexgen, under the assumption of independent defaults, it is better to make up a portfolio
containing as many bonds as possible. We, therefore, select the 20 highest yielding bonds from
the available set. These bonds can be found in Table 1 in the Appendix.

We extended the basic result that under default independence, the probability of 1 bond
defaulting in a two bond portfolio is :

P (single def ault) = P DA (1 − P DB ) + P DB (1 − P DA )

The code used to compute the default probabilities for a given number of simultaneous defaults
is included in the Appendix. Table 2 shows the probabilities of simultaneous defaults for 1 to 3
bonds for portfolios containing various numbers of bonds. This illustrates the previous point that
under independent default it is advantageous for Nexgen to put as many bonds as collateral in
this CDO as possible. It also illustrates that probabilities of simultaneous default get very small,
very fast. Moreover, Table 2 shows that the probability of 3 bonds defaulting is 0.29% which is
within the client’s acceptable risk range.

Thus Junior tranche attachment point is 10%. In other words, two bonds will need to default
before the client starts facing losses. Given the bonds in the CDO and under the assumption of
uncorrelated defaults, this corresponds to a default rate of 0.29%. The total spread of these
bonds is ​897​ basis points.

The exact allocation of this spread would require more information on Nexgen’s objectives,
however, given the clients’ foremost need for safety, we assume that they would be willing to
accept a very low spread. We, therefore,based on the spread that AAA-rated bonds has in the
Nexgen’s sample bond portfolio(Federal National Mortgage - 20.3bp,General Electric Capital
Corporation - 24.5bp,MBIA Insurance Corp - 32.5bp) suggest that around ​20-30bp be given to
the client’s senior tranche, with the rest going to Nexgen. Though this is not a fixed amount, we
believe that Nexgen should receive a minimum spread of ​850 bp​ for this CDO to acceptable.

Appendix

Selected Bonds

Table 1: Selected bonds

Legal name Spread 5 Recovery Default Industry Sector Rating

year Rate Probability

Volkswagen AG 63.5 0.35 4.79% Automobile A-

Boots Group Plc 60.5 0.5 5.91% Retail Stores A+

Hutchison 53 0.45 4.73% Diversified/Conglomerate A-

Whampoa Ltd. Manufacturing

BT Group Plc 52.8 0.4 4.32% Telecommunications A-

Skandia 50 0.45 4.46% Insurance BBB

Forsakrings AB

Countrywide Home 46.5 0.5 4.56% Banking A

Loans Inc

Wyeth 45.3 0.35 3.44% Healthcare, Education & A

Childcare

Radian Group Inc 44.3 0.3 3.12% Insurance A

Hartford Fini. 42 0.35 3.19% Insurance A-

Services Group

Southwest Airlines 39.5 0.35 3.00% Personal Transportation A

Co
 XL Capital Ltd 39.5 0.3 2.79% Insurance A+

Korea Highway 38 0.45 3.41% Buildings & Real Estate A-

Corp

Viacom Inc 38 0.4 3.13% Broadcasting & A-

Entertainment

Washington Mutual 38 0.5 3.74% Banking A-

Inc

EnCana Corp 37 0.4 3.05% Oil & Gas A-

Hammerson Plc 37 0.45 3.32% Finance A-

International Lease 37 0.35 2.81% Insurance AA-

Finance

Transocean Inc. 35 0.45 3.14% Oil & Gas A-

CIT Group Inc 34.3 0.4 2.83% Finance A

Sk Telecom Co Ltd 33.3 0.5 3.29% Telecommunications A

Export-Im port Bank 32.5 0.4 2.68% Finance A-

Of Korea

Default Probabilities
Note: We have only listed the probabilities up to 3 defaults, as beyond this the probabilities are
essentially zero.

Table 2: Default Probabilities

# BONDS Pr(1 default) Pr(2 default) Pr(3 defaults)

1 1.17% NA NA

2 2.33% 1.19% NA

3 3.85% 0.05% 0.04%

4 5.07% 0.10% 0.04%

5 6.20% 0.16% 0.00%

6 7.22% 0.23% 0.00%

 7 8.23% 0.32% 0.01%

8 9.52% 0.44% 0.01%

9 10.90% 0.60% 0.02%

10 12.25% 0.77% 0.03%

11 13.21% 0.92% 0.04%

12 14.34% 1.11% 0.05%

13 15.55% 1.34% 0.07%

14 16.73% 1.59% 0.09%

15 17.88% 1.86% 0.12%

16 18.99% 2.14% 0.15%

17 19.98% 2.42% 0.18%

18 20.81% 2.68% 0.22%

19 21.67% 2.96% 0.25%

20 22.45% 3.23% 0.29%

Code
# setup ---------------------------------------
setwd("C:/Users/thepo/Dropbox/18HS/Cours/Derivatives/CDO Case")
rm(list = ls())
raw <- read.csv("Nexgen_data.csv", skip = 2, stringsAsFactors = FALSE)

maxbond <- 20

at_pt <- vector()

tot_spread <- vector()

for ( c in 1:maxbond){ # CDOs of varying size

nbond <- c

# preallocation -------------------
 # subset is first nbond bonds with largest spread
subs_ind <- sort(raw$Spread.5.year, index.return = TRUE)$ix[1:nbond]
subs <- raw[subs_ind,]

prod <- vector()

p <- as.numeric(subs$Default.Probability)
np <- 1-p

# cump[i] is the probability of i bonds defaulting

cump <- vector()

# probability loop ----------------

for (j in 1:nbond){ # for the considered size, the pr(d) for j bonds

ndef <- j
ind <- combn(nbond, ndef)

for(i in 1:(dim(ind)[2]) ){

# ​NOTE: ​this is the line which computes the actual default probabilities
prod[i] <- prod(p[ind[,i]]) * prod(np[-ind[,i]])

cump[j] <- sum(prod)

# output of interest --------------------

# the attachement point for the junior tranche is
at_pt[c] <- max(which(cump > 0.003))/nbond

# the total spread to be distributed is

tot_spread[c] <- sum(subs$Spread.5.year)

rm(cump, subs, subs_ind, i, j, ndef,ind, prod, nbond)