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FRM Part II · FRM Exam Part II · Structured Credit Risk

A pool of 1,000 million of loans pays a weighted average coupon of 7%. Notes of 900 million pay 5% and the 100 million equity piece receives residual cash. Servicing and fees cost 0.5% of the pool annually. Assuming no losses, what is the annual excess spread in money terms, and what does it represent for the structure?

Excess spread is 20 million per year: 70 million of pool interest less 45 million of note interest and 5 million of fees. It serves as the first layer of credit enhancement, absorbing losses before tranche principal is hit.

  1. A20 million, available as first credit enhancementCorrect
  2. B70 million, paid entirely to senior notes
  3. C25 million, available as first credit enhancement
  4. D45 million, a cost to equity holders

Explanation

Interest income is 70 million. Note interest is 900 x 5% = 45 million and fees are 5 million. Excess spread = 70 - 45 - 5 = 20 million. It is the first line of defense against losses, absorbing them before principal credit enhancement. The 25 million option omits fees.

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