1. Assume that the default probability for a company in a year, conditional on no earlier defaults is λ and the recovery rate is R. The risk-free interest rate is 5% per annum. Default always occurs halfway through a year. The spread for a 5-year plain vanilla CDS where payments are made annually is 120 basis points and the spread for a 5-year binary CDS where payments are made annually is 160 basis points. Estimate R and λ.
2. Explain how you would expect the returns offered on the various tranches in a synthetic CDO to change when the correlation between the bonds in the portfolio increases.