For problem number 28 in Reading 55 Mortgage backed sector of the Bond Market, I am looking at the solutions and I can not understand how they came up with the 8% IO notional amt. Can someone please explain the calcuation? Thanks
Not looking at it but I think it should be (expected cash flow)/.08.
The interest payment of this IO tranche is financed by whatever interest payment is left after interest payment of the other tranches, i.e., financed by excess interest which is = coupon of collateral - coupon rate of the other tranches So for the tranche A: the excess interest (left over interest) is 400M* (8%-6.25%= 1.75%) = 7M. This 7 M will be used to pay as interest for the IO tranche. Similarly, you have 2.5M for tranche B,… In total, you have 7+2.5+1.125+.4375M = 11.063M leftover after having paid interest for tranche A-D. Since the agreed interest of the IO tranche is 8%, you have notional amount*8%= 11.063M or 11.063M/8%= notional amount.
THANKS FOR YOU HELP