PQ-external Excess spreads question~

[no_ming]

Hi, Mr @David Harper , for the following question, although I get the correct answer, I still doubt on the calculation of excess spread = 0.65% becasue the base of inflow of outflow is different (i.e. 600mn vs 570mn)

My calculation is: 600mn*(8.75%-0.60%) - 570mn*(7.5%) rather than 0.65%, do you agree?

 

[David Harper CFA FRM]

Hi @no_ming Yes, I agree with you. The calculation looks incorrect to me. Like you, I get:

• gross excess spread = 600*8.75% - 570*7.50% = $9.75 mm or 9.75/600 = 1.625%, and
• net excess spread = = 600*(8.75% - 0.60%) - 570*7.50% = $6.15 mm or 6.15/600 = 1.025%. Thanks!

 

[no_ming]

Hi, Mr Harper, for the above question, should I deducted the defaulted the GBP 6.625mn first when I calculate the interest received from the loans?

That is (GBP 80mn - GBP 6.625mn)*LIBOR+3% as I am questioned about whether I should include the interest from the defaulted portion. Thx

 

[David Harper CFA FRM]

Hi @no_ming Your question is good because sometimes default is assumed to refer to only the principal (as your solution infers), however here (in my opinion) the question does specify "accumulates 6.625 mm of losses from defaults and unpaid interest." And, this is natural (yes?): losses should refer to both unpaid principal and unpaid interest. So, given the phrasing, appropriate would be 80.0*(1 + 1% + 3%) - 6.625 = 76.5750; i.e., losses subtracted from everything owed makes sense. And this, by design no doubt, leaves as the left over amount exactly the amount needed to repay both debt tranches: 65*(1 + 0.5% + 1%) + 10*(1+ 5% + 1%) = 76.570; an exact match. In this way, the answer (B) is justified even if there is room for improvement in the question (including the compound frequency is not given). Thanks,