Question 1

A financial institution plans to issue a group of bonds backed by a pool of automobile loans.However,they fear that the default rate on the automobile loans will rise well above 4 percent of the portfolio-the projected default rate.The financial institution wants to lower the interest payments if the loan default rate rises too high.Which type of credit derivative contract would you most recommend for this situation?

Accepted Answer

A Credit-linked note (CLN) is a form of a structured financial instrument that combines a bond with a credit derivative. In this scenario, the financial institution can issue a CLN where the interest payments are linked to the performance of the automobile loans. If the default rate on the loans rises above a certain threshold (e.g., 4 percent), the interest payments on the CLN can be adjusted accordingly, thus lowering the payments and mitigating the risk of higher defaults.

Question 2

The principal sellers of risk protection via credit derivatives include all of the following except:

Accepted Answer

The answer of The principal sellers of risk protection via...

Question 3

Loans that are to be securitized are passed on to ____________.This helps ensure that if the lender goes bankrupt,it does not affect the credit status of the pooled loans.

Accepted Answer

Securitization involves pooling together individual loans to form a new financial instrument that can be sold to investors. To ensure that the credit status of the pooled loans is protected even if the originator goes bankrupt, a special-purpose entity (SPE) is created. The SPE purchases and holds the loans, issues securities to investors, and uses the cash flows from the underlying loans to pay the interest and principal on those securities. The trustee oversees the operations of the SPE, while the servicer manages the day-to-day administration of the loans. The credit enhancer provides credit protection to the investors. Therefore, the best choice is B because the SPE is responsible for holding the loans and issuing securities.

Question 4

A bank plans to offer new subordinated notes in the open market next month but knows that its credit rating is being reviewed by a credit rating agency.The bank wants to avoid paying sharply higher credit costs.Which type of credit derivative contract would you most recommend for this situation?

Accepted Answer

The answer of A bank plans to offer new subordinated...

Question 5

When two banks simply agree to exchange a portion of their customers' loan repayments,they are using:

Accepted Answer

When two banks agree to exchange a portion of their customers’ loan repayments, they are using a credit swap. A credit swap is a financial contract in which two parties agree to exchange the credit risk of one another. It is typically used to transfer the risk of default on a loan or bond from one party to another. In this case, the banks are exchanging the credit risk associated with their loans.

Question 6

If a credit letter is issued to backstop payments on loan-backed securities,the credit letter is a form of:

Accepted Answer

A credit letter issued to backstop payments on loan-backed securities is a form of credit enhancement. It provides investors with an added level of security by guaranteeing the timely repayment of interest and principal on the securities even if the loan borrowings were to fail. This enhances the credit quality of the loan-backed securities, making them more attractive to investors.

Question 7

A bank or any other lender whose loans are pooled is called:

Accepted Answer

The originator is the bank or lender that initially creates the loans that are then pooled in various types of financial transactions, such as mortgage-backed securities.

Question 8

A hybrid instrument which allows the issuer to lower its coupon payments if some significant factor changes is called:

Accepted Answer

A credit-linked note is a hybrid instrument that allows the issuer to lower its coupon payments if some predefined credit event (such as a default or credit downgrade of a specified reference entity) occurs. This feature provides the issuer with some credit protection and can make the note more attractive to investors. Choice A (credit option) is a general term that could refer to various types of financial instruments, but it does not specifically match the description of a credit-linked note. Choice B (standby letter of credit) is a type of guarantee issued by a bank to ensure payment to a beneficiary if the client fails to fulfill its obligation, and is not directly related to coupon payments on debt securities. Choice D (credit swap) involves the exchange of cash flows based on a predetermined reference credit, but it does not include the feature of coupon payment reduction.

Question 9

A bank that wants to protect itself from higher borrowing costs due to a decrease in its credit rating might purchase:

Accepted Answer

A credit risk option allows the bank to hedge against the risk of its credit rating being downgraded, which could lead to higher borrowing costs.

Question 10

A securitized asset where the asset used to back the securities is a loan based on the residual value of a homeowner's residence is called:

Accepted Answer

The asset used to back the securities in this case is a loan based on the residual value of a homeowner's residence, which is specifically referred to as a home equity loan, making E the most appropriate choice. The other options involve assets from different types of loans.

Question 11

A bank is about to make a $50 million project loan to develop a new oil field and is worried that the petroleum engineer's estimates of the yield on the field are incorrect.The bank wants to protect itself in case the developer cannot repay the loan.Which type of credit derivative contract would you most recommend for this situation?

Accepted Answer

The answer of A bank is about to make a...

Question 12

A bank has a limited geographic area of operations.It would like to diversify its loan income with loans in other market areas but does not want to actually make loans in those areas because of its limited experience in those areas.Which type of credit derivative contract would you most recommend for this situation?

Accepted Answer

A credit swap is the most appropriate choice as it allows the bank to transfer credit risk associated with loans in other market areas to another party who is able to assume that risk in exchange for a fee. This way, the bank can earn income from loans in other areas without having to actually make the loans or assume the associated credit risk.

Question 13

According to the text,in 2005 the securitization of loans reached:

Accepted Answer

In 2005, the securitization of loans reached the trillion dollar market, indicating a significant level of financial activity in converting loans into tradable securities.

Question 14

A bank has a long-term relationship with a particular business customer.However,recently the bank has become concerned because of a potential deterioration in the customer's income.In addition,regulators have expressed concerns about the bank's capital position.The business customer has asked for a renewal of its $25 million dollar loan with the bank.Which of the following can be used to help this situation?

Accepted Answer

Selling the loan (Loan sale) can help the bank reduce its exposure to the potentially deteriorating credit risk of the business customer, while also improving its capital position as required by regulators.

Question 15

Which of the following is a risk of using credit derivatives?

Accepted Answer

The partner in a credit derivative contract may fail to perform, leading to potential losses for the other party involved. While A, C, and D are all potential outcomes of regulatory decisions, they are not inherent risks of using credit derivatives. Option E is incorrect as it includes option A, which is inaccurate.

Question 16

A bank has placed 5,000 consumer loans in a package to be securitized.These loans have an annual yield of 15.25 percent.The bank estimates that the securities on these loans are priced to yield 10.95 percent.The bank's default (charge-off)rate on the pooled loans is expected to be 1.45 percent.Underwriting and advisory services will cost 0.25 percent,and a credit guarantee,if more loans default than expected,will cost 0.35 percent.What is the residual income from this loan securitization?

Accepted Answer

The answer of A bank has placed 5,000 consumer loans...

Question 17

Securitization is used by the banks to:

Accepted Answer

Securitization allows banks to raise funds by creating tradable securities backed by assets, such as loans or mortgages. This helps to diversify funding sources, allocate capital more efficiently, and lower the cost of raising funds. Therefore, all the options are correct.

Question 18

Loan sales by banks are generally of two types: (a)participation loans;and (b)_________.The term that correctly fills in the blank above is:

Accepted Answer

The blank is asking for the second type of loan sale, and among the given options, only "assignments" is a type of loan sale. Assignment is a process where a bank sells all or a portion of the rights and obligations of a loan to another financial institution or investor. This allows the originating bank to reduce its exposure to risk and increase liquidity, while the buyer of the loan gains access to a diversified portfolio of loans. Therefore, the correct choice is A) assignments.

Question 19

For an issuer,a standby credit letter is a(n):

Accepted Answer

A standby credit letter is a contingent obligation which is a commitment by the issuer to make a payment in the event that the beneficiary of the letter fails to fulfill its obligations. It is not a securitized strip, loan strip, or indirect loan.

Question 20

A bank is concerned about excess volatility in its cash flows from some recent business loans it has made.Many of these loans have a fixed rate of interest and the bank's economics department has forecast a sharp increase in interest rates.The bank wants more stable cash flows.Which type of credit derivative contract would you most recommend for this situation?

Accepted Answer

A total-return swap is the most suitable credit derivative contract in this situation because it allows the bank to exchange the fixed interest payments it receives from the business loans for payments that are more closely tied to the current interest rates, thus reducing the volatility in its cash flows caused by the forecasted sharp increase in interest rates.

Quiz 9: Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives