A pool of high yield bonds is placed in an SPV and three tranches(including the equity tranche)of bonds are issued collateralized by the bonds to create a Collateralized Bond Obligation(CBO).Which of the following is true?
A.At fair value,the value of the issued bonds should be less than the collateral
B.At fair value,the total default probability，weighted by size of issue,of the issued bonds should equal the default probability of the collateral pool
C.The equity tranche of the CBO has the least risk of default
D.The yield on the low risk tranche must be greater than the yield on the collateral pool
Answer:B
A Collateralized Bond Obligation and the underlying securities must have equal market value,similar cash flow pattern and identical risk,which eliminate choice A in favor of B.The equity tranche has the greatest risk of default;the yield on the low risk tranche must be less than the yield on the collateral pool.
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