Mathematics for Computer Science

Chapter 18 Deviation from the Mean658

super bond can then be itself separated into tranches, which are again ordered

to indicate how to assign losses.

(a)Suppose that 1000 loans make up a bond, and the fail rate is 5 % in a year.
Assuming mutual independence, give an upper bound for the probability that there
are one or more failures in the second-worst tranche. What is the probability that
there are failures in the best Tranche?

(b)Now, do not assume that the loans are independent. Give an upper bound for
the probability that there are one or more failures in the second tranche. What is an
upper bound for the probability that the entire bond defaults? Show that it is a tight
bound.Hint:Use Markov’s theorem.

(c)Given this setup (and assuming mutual independence between the loans), what
is the expected failure rate in the mezzanine tranche?

(d)We take the mezzanine tranches from 100 bonds and create a CDO. What is
the expected number of underlying failures to hit the CDO?

(e)We divide this CDO into 10 tranches of 1000 bonds each. Assuming mutual
independence, give an upper bound on the probability of one or more failures in the
best tranche. The third tranche?

(f)Repeat the previous question without the assumption of mutual independence.

Homework Problems

Problem 18.19.
An infinite version of Murphy’s Law is that if an infinite number of mutually inde-
pendent events are expected to happen, then the probability that only finitely many
happen is 0. This is known as the firstBorel-Cantelli lemma.

(a)LetA 0 ;A 1 ;:::be any infinite sequence of mutually independent events such
that X

n 2 N

PrŒAnçD1: (18.30)

Prove that PrŒnoAnoccursçD 0.

Hint:Bkthe event that noAnwithnkoccurs. So the event that noAnoccurs is

BWWD

\

k 2 N

Bk:

Apply Murphy’s Law, Theorem 18.7.4, toBk.