Instructions:

Only answer 3 questions and include at least one reference:

1) What is a credit default swap (CDS)? Consider the cash-flow pattern of the CDS in Exhibit 2 of From free lunch to black hole: Credit Default Swaps at AIG . Can you set up a trading strategy using long and short positions of the default-free floating rate bond and the defaultable floating rate bond that replicates the cash flow pattern of the CDS? Given the coupon rate on the defaultable floating rate bond, can you determine the CDS rate based on the law of one price?
2) Review Exhibits 3-6 of From free lunch to black hole: Credit Default Swaps at AIG . What was AIG’s role in the process of mortgage securitization? How did the Bistro deal work? How does the mortgage securitization work? What are super-senior tranches and what is their purpose?
3) How risky are BBB-tranches in the first layer of securitization?
4) How risky are super-senior tranches in the second layer? Should one view a super-senior tranche as safer than an AAA-rated corporate bond?
5) Is it possible that AIG could experience big losses on its super-senior CDS positions? Are collateral calls justified?
Use your own words. Directly copying and pasting from web and other sources constitutes academic plagiarism.
Please support your statements with relevant resources from the textbook, the financial press, or the academic articles.

week 5 Forum: Credit default swaps