Deck 31: Market for Credit Risk Transfer Vehicles: Credit Derivatives and Collateralized Debt Obligations

Question 1

Credit derivatives, particularly ________, allow the transfer of credit risk to another party without the sale of the loan.

A) special purpose vehicles
B) special purpose swap
C) credit default swaps
D) credit default vehicles

Answer 1

C

Question 2

Which of the below statements is FALSE?

A) The standard single-name credit default swap when the reference entity is a corporate bond or a sovereign bond is fixed based on a notional amount.
B) If no credit event has occurred by the maturity of the swap, both sides renegotiate the swap agreement so that further obligations are incurred.
C) A credit default swap can specify at the contract date the exact amount of payment that will be made by the protection seller should a credit event occur.
D) A standard credit default swap specifies quarterly payments.

Answer 2

B

Question 3

Portfolio managers can have a dealer create a ________ equal to the maturity of the reference obligation or have it constructed for a shorter time period to match the manager's investment horizon.

A) tutor
B) tenor
C) maturity
D) length

Answer 3

B

Question 4

In January 2003, the ISDA published its revised credit events definitions in the 2003 ISDA Credit Derivative Definitions. In regards to these definitions, which of the below statements is FALSE?

A) A minor change involved restructuring.
B) One of these definitions involved no restructuring.
C) One of these definitions did not involve full or old restructuring.
D) The major change was to repudiation.

Question 5

The payment by the credit protection seller if a credit event occurs may ________.

A) not be a predetermined fixed amount.
B) be determined by the decline in value of the reference entity.
C) be determined by the increase in value of the reference obligation.
D) be determined by the decline in value of the reference obligation.

Question 6

The interdealer market has evolved to where single-name credit default swaps for corporate and sovereign reference entities are ________.

A) customized.
B) standardized.
C) nonstandardized.
D) institutionalized.

Question 7

A ________ occurs when the terms of the obligation are altered so as to make the new terms less attractive to the debt holder than the original terms.

A) cross default
B) restructuring
C) downgrading
D) repudiation

Question 8

Credit default swaps ________.

A) are used to shift credit exposure to a credit protection seller.
B) have a secondary purpose to hedge the credit exposure to a particular asset or issuer.
C) have one reference obligation called a single-name credit default swap.
D) are referred to as a basket credit default swap when there is a single reference entity.

Question 9

The 1999 ISDA Credit Derivatives Definitions (referred to as the "1999 Definitions") provides a list of eight credit events: Which of the below includes three of these eight credit events?

A) bankruptcy, credit event upon merger, and cross deceleration.
B) cross hedge, downgrade, and failure to pay.
C) repudiation / moratorium, restructuring, and cross default.
D) repudiation / natatorium, bankruptcy, and failure to pay.

Question 10

________ is defined as a variety of acts that are associated with bankruptcy or insolvency laws.

A) Bankruptcy
B) Merging for a credit event
C) Downgrading
D) Restructuring

Question 11

Credit derivatives are used by institutional portfolio managers in the normal course of activities to more efficiently ________.

A) control the market risk of a portfolio.
B) control the balance sheet of a financial institution.
C) transact than by avoiding the cash market.
D) deleverage an exposure in the credit market.

Question 12

________ means that if a credit event as defined by the documentation occurs, the reference obligation is delivered by the protection buyer to the protection seller in exchange for a cash payment.

A) Documentation
B) Cash delivery
C) Physical delivery
D) Protection delivery

Question 13

Which of the below statements is FALSE?

A) The reason why restructuring is so trouble-free is that a protection buyer benefits from the inclusion of restructuring as a credit event and feels that eliminating restructuring as a credit event will erode its credit protection.
B) If the reference obligation is a loan and the protection buyer is the lender, a benefit is that the protection buyer receives a payment from the protection seller.
C) If the reference obligation is a loan and the protection buyer is the lender, a benefit is that the accommodating restructuring fosters a relationship between the lender and its customer.
D) As the credit derivatives market developed, market participants learned a great deal about how to better define credit events.

Question 14

The ________ developed a standardized contract that could be used by parties to trades of a credit derivatives contract.

A) International Swap and Derivatives Association (ISDA)
B) Domestic Derivatives and Futures Association (DDFA)
C) International Credit Swap Association (ICSA)
D) International Swap and Futures Association (ISFA)

Question 15

The reference entity ________.

A) is the issuer of the debt instrument and hence is also referred to as the reference issuer.
B) is the particular debt issue for which the credit protection is being sought.
C) could not be Ford Motor Credit Company.
D) could be Ford Motor Credit Company bond issue

Question 16

Credit derivatives can be used to create credit risk transfer products. The two most common products employing credit default swaps are ________.

A) synthetic CDOs and credit-linked notes.
B) synthetic CDOs and credit-linked CDOs.
C) synthetic notes and credit-linked notes.
D) nonsynthetic notes and credit-linked CDOs.

Question 17

In a ________, the protection buyer pays a fee to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit event by the reference obligation or the reference entity.

A) credit event swap
B) credit protection swap
C) protection default swap
D) credit default swap

Question 18

The most controversial credit event that may be included in a credit derivative product is restructuring of an obligation. A restructuring occurs when the terms of the obligation are altered so as to make the new terms less attractive to the debt holder than the original terms. Term that can be changed are a ________.

A) reduction in the interest rate and a reduction in the principal.
B) rescheduling of the principal repayment schedule and a reduction in the principal.
C) change in the level of seniority of the obligation in the reference entity's debt structure and a reduction in the interest rate.
D) All of these

Question 19

The reference obligation ________.

A) is the issuer of the debt instrument and hence is also referred to as the reference issuer.
B) could be a corporation or a sovereign government.
C) is the particular debt issue for which the credit protection is being sought.
D) could be Ford Motor Credit Company.

Question 20

Credit derivative products have ________ that is contingent upon a ________ occurring.

A) a payback; credit effect
B) a payout; credit event
C) an expense; debit outcome
D) a fee; credit result

Question 21

CDOs are categorized based on the motivation of the sponsor of the transaction. If the sponsor's motivation is to earn the spread between the yield offered on the collateral and the payments made to the various tranches in the structure, then the transaction is referred to as ________.

A) a collateral transaction.
B) an arbitrage transaction.
C) a motivational transaction.
D) All of these

Question 22

When the underlying pool of debt obligations consists of bond-type instruments (corporate and emerging market bonds), a CDO is referred to as a ________. When the underlying pool of debt obligations is bank loans, a CDO is referred to as a ________.

A) collateralized loan obligation (CLO); collateralized bond obligation (CBO)
B) collateralized bond security (CBS); collateralized loan obligation (CLO)
C) collateralized bond obligation (CBO); collateralized loan security (CLS)
D) collateralized bond obligation (CBO); collateralized loan obligation (CLO)

Question 23

In regards to a CDO structure, which of the below statements is TRUE?

A) In a CDO structure, there is a collateral manager responsible for managing the portfolio of debt obligations.
B) The portfolio of debt obligations in which the collateral manager invests is referred to as the portfolio.
C) The individual issues held that comprise the collateral are referred to as the collateral liabilities.
D) These debt obligations are referred to as tranches or bond classes. The tranches include: junior tranches, mezzanine tranches, and equity tranche

Question 24

A collateralized debt obligation (CDO) is a security backed by a diversified pool of one or more types of debt obligations that include ________.

A) U.S. domestic investment-grade and high-yield corporate bonds and U.S. domestic bank loans.
B) emerging market bonds and special situation loans and distressed debt.
C) foreign bank loans and asset-backed securities.
D) All of these

Question 25

In regards to a structured finance operating company (SFOC), which of the below statements is FALSE?

A) An SFOC sounds much like an arbitrage CDO since both use borrowed funds to generate a return from investing in a pool of credit-risky assets.
B) There is only one type of SFOC.
C) Unlike a CDO, the manager of an SFOC can increase or decrease its leverage based on its expectation about factors that impact the return on its portfolio.
D) The most popular type of SFOC is the structured investment vehicle (SIV).

Question 26

Basically what an SFOC seeks to do is ________.

A) generate "arbitrage" returns by lending funds.
B) invest borrowed funds in such a way to earn less than the cost of the funds.
C) invest borrowed funds in credit-safe debt.
D) generate "arbitrage" returns by borrowing funds.

Question 27

Which of the below statements is FALSE?

A) In the absence of a credit event, the protection buyer will make a quarterly swap premium payment over the life of the swap.
B) If a credit event occurs, there are no further payments of the swap premium by the protection buyer to the protection seller.
C) If a credit event occurs, a termination value is determined for the swap.
D) With physical settlement the protection seller delivers a specified amount of the face value of bonds of the reference entity to the protection buyer.

Question 28

The proceeds to meet the obligations to the CDO tranches (interest and principal repayment) can come from coupon interest payments from the ________.

A) coupon interest payments from the collateral assets.
B) maturing of collateral assets
C) sale of collateral assets
D) All of these

Question 29

________ is a security issued by an investment banking firm or another issuer (typically a special purpose vehicle), which has credit risk to a second issuer (called the reference issuer), and the return is linked to the credit performance of the reference issuer.

A) A structured finance operating company (SFOC)
B) An equity-linked note (ELN)
C) A credit-linked debenture (CLD)
D) A credit-linked note (CLN)

Question 30

In regards to a CDO structure, at least an A rating is typically sought for the ________ at least a B rating is sought for the ________.

A) mezzanine tranches; subordinate/equity tranches
B) subordinate/equity tranches; mezzanine tranches
C) senior tranches; mezzanine tranches
D) senior tranches; subordinate/equity tranches

Question 31

A synthetic CDO absorbs the ________, but not the ________, of the reference obligations.

A) positive risk; promised ownership
B) market risk; legal ownership
C) credit risk; legal ownership
D) default risk; book ownership

Question 32

Cash CDOs went a long way in providing banks with the opportunity to better manage their balance sheet. However, problems with cash CDOs including ________.

A) regulations allowed for more inefficient ways for obtaining credit protection in order to reduce capital requirements.
B) the problem of confidentiality.
C) regulations allowed for more efficient ways for obtaining credit protection in order to increase capital requirements
D) None of these

Question 33

Which of the below statements is TRUE?

A) In a credit default swap index, the credit risk of a standardized basket of reference entities is not transferred between the protection buyer and protection seller.
B) The mechanics of a credit default swap index are entirely different from that of a single-name credit default swap.
C) The parties to a credit default swap are the credit protection buyer and the credit protection seller, the latter providing protection should a credit event occur for a reference entity or pool of reference entities during the life of the contract and the former making periodic payments for the protection.
D) There are only two types of credit default swaps: single-name credit default swap and credit default swap indexes.

Question 34

A credit-linked debenture (CLD) ________.

A) is a credit derivative, typically a credit default swap.
B) cannot be complicated.
C) is the credit protection seller; the investor in the CLN is the credit protection buyer
D) is unlike a standard bond.

Question 35

Which of the below statements is FALSE?

A) If a credit event occurs that requires a payout, the collateral manager must make a payment to the protection buyer.
B) There are now standard synthetic CDO tranches that can be purchased by investors based on a standardized reference portfolio.
C) The motivation in a balance sheet transaction is to retain loans on a financial institution's balance sheet and obtain capital relief.
D) A synthetic CDO uses credit derivatives, most commonly credit default swaps, to create exposure to reference entities rather than purchasing the cash instruments of those reference entities themselves.

Question 36

In determining whether or not to create a CDO, dealers will look to see if there is a potential return available to the equity tranche of ________.

A) a minimum amount.
B) a maximum amount.
C) an interest-free amount.
D) a perfect amount.

Question 37

Which of the below statements is TRUE?

A) A CDO is a security backed by a nondiversified pool of debt obligations.
B) The CDO collateral manager is not responsible for managing the portfolio of debt obligations.
C) Collateralized loan obligations and collateralized bond obligations are types of CDOs.
D) The funds to purchase the assets for a CDO are obtain from the sale of securities and these securities do not include senior tranches, mezzanine tranches, and a subordinate/ equity tranche.

Question 38

________ is a term used by Moody's to refer to an entity whose business activities and operations as well as its credit rating are based on detailed, predetermined parameters.

A) A structured finance operating company (SFOC)
B) A structured finance cooperative (SFC)
C) An organized finance operating company (OFOC)
D) An organized finance cooperative (OFC)

Question 39

Assume a hypothetical credit default swap where the notional amount is $10 million and there are 92 actual days in a quarter. If the swap premium is 400 basis points (0.04), what is the quarterly swap premium payment made by the protection buyer?

A) $51,111
B) $75,333
C) $102,222
D) $125,378

Question 40

Which of the below statements is FALSE?

A) If a payout is triggered only after two reference obligations default, the swap is referred to as a first-to-default basket swap.
B) Single-name credit default swaps can be used in the swap market by portfolio managers to leverage their position in a corporate bond.
C) From the list of deliverable obligations, the protection buyer will select for delivery to the protection seller the cheapest-to-deliver issue.
D) Since all reference entities that are the subject of credit default swaps have many issues outstanding, there will be a number of alternative issues of the reference entity that the protection buyer can deliver to the protection seller. These issues are known as deliverable obligations.

Question 41

In a credit default swap index, the credit risk of a standardized basket of reference entities is transferred between the protection buyer and protection seller with the contract continuing even if there is a credit event for any of the reference entities in the basket but at a lower premium to reflect the credit protection for less reference entities.

Question 42

The concerns with credit derivatives and, therefore, synthetic CDOs being used as CRT vehicles include ________.

A) a concern with counterparty risk.
B) a concern with legal risks that may arise from a transaction.
C) a concern with the failure of the counterparty selling credit protection would result in the buyer of credit protection maintaining the credit exposure that it thought it had eliminated.
D) All of these

Question 43

Two recent credit risk transfer vehicles are credit derivatives and collateralized debt obligations (CDOs).

Question 44

In a basket credit default swap, there are multiple reference entities with the trigger determining when the protection buyer must make a payment to the protection seller being based on the number of reference entities that must default.

Question 45

The motivation in an arbitrage transaction is to earn an attractive spread for the debt tranche.

Question 46

The introduction of ________ vehicles, such as cash CDOs and credit derivatives that are employed to create synthetic CDOs, has elicited the same cautious response from overseers of the global banking system.

A) old credit risk transfer
B) new default risk transport
C) new cask risk transfer
D) new credit risk transfer

Question 47

In regards to a credit-linked note (CLN), which of the below statements is FALSE?

A) In contrast to a standard bond, the maturity value does not depend on the performance of the reference issuer.
B) If a credit event occurs with respect to the reference issuer, then (1) the bond is paid off, and (2) the maturity value is adjusted down.
C) The compensation for the investor accepting the credit risk of the reference issuer is an enhanced coupon payment.
D) Typically, CLNs have a maturity of anywhere from three months to several years, with one to three years being the most likely term of credit exposure.

Question 48

Studies have identified regulatory and supervisory concerns with CRT vehicles, such as credit derivatives and CDOs. From these studies, four general issues were identified including ________.

A) clean risk transfer.
B) risk of success of market participants to understand associated risk.
C) potentially low concentration of risk.
D) favorable selection.

Question 49

A credit default swap is a trivial type of credit derivative.

Question 50

With a single-name credit default swap, there is only one reference entity and once a credit event occurs, the protection seller must compensate the protection buyer (either physical or cash settlement); payment by the protection buyer to the protection seller end either when a credit event occurs or the maturity date of the contract is reached.

Question 51

Credit derivatives are used by institutional portfolio managers to more efficiently control the credit risk of a portfolio rather than the balance sheet of a financial institution.

Question 52

Which of the below statements is FALSE?

A) For credit risk transferred out of the banking system, there is the concern with the extent to which credit risk is being transferred to nonbanks, such as monoline or multiline insurance companies and hedge funds.
B) Within the insurance industry, the largest seller of credit protection is financial guarantors, insuring the senior tranches in synthetic CDO deals.
C) The ability of originators to transfer credit risk via credit derivatives, CDOs, or securitization has raised concerns that a lending culture based on origination volume rather than prudent lending practices may be inadvertently adopted by banks.
D) None of these

Question 53

In a synthetic CDO, payments to the tranches issued are generated from the collateral's coupon interest and principal from maturing or prepaid debt obligations.

Question 54

The ISDA documentation for a credit derivative trade identifies the reference entity and what constitutes a credit event that sets forth when a payout must be made by the protection seller to the protection buyer.

Question 55

The International Swap and Derivatives Association (ISDA) has facilitated the growth of the credit derivative market by introducing a tailor-made contract that can be used in credit derivative trades.

Question 56

CDOs are categorized based on the motivation of the sponsor of the transaction: arbitrage transactions and balance sheet transactions.

Question 57

There are eight types of credit events possible, the most controversial being restructuring.

Question 58

A ________ can result in either the transfer of the credit risk from one bank to another or from a bank to a nonbank entity.

A) cart vehicle
B) bank vehicle
C) bank entity
D) CRT vehicle

Question 59

In the case of a financial institution that seeks to make a market in the new CRT vehicles, there is a concern that in selling more complex products, such as synthetic CDOs, they may not be properly hedging their position and therefore ________.

A) maintaining the institution's risk.
B) decreasing the institution's risk.
C) increasing the institution's risk.
D) All of these

Question 60

There are four types of credit default swaps: single-name credit default swap, multiple-name credit default swap, basket credit default swaps, and credit default swap indexes.

Question 61

What is the most controversial credit event that may be included in a credit derivative product? When does this controversial credit event occur?

Question 62

A CRT vehicle can result in either the transfer of the credit risk from one bank to another or from a bank to a nonbank entity.

Question 63

Arbitrage transactions can be divided into two types depending on the primary source of the proceeds from the collateral to satisfy the obligation to the tranches. Describe these two types.

Question 64

A structured finance operating company (SFOC) is a term used by Moody's to refer to an entity whose business activities and operations as well as its credit rating are based on detailed, predetermined parameters.

Question 65

A credit-linked note (CLN) is a security issued by an investment banking firm or another issuer (typically a special purpose vehicle), which has credit risk to a second issuer (called the reference issuer), and the return is linked to the credit performance of the reference issuer.

Question 66

What is credit-linked note (CLN)? Can it be complicated?

Question 67

Credit derivative products have a payout that is contingent upon a credit event occurring. The ISDA provides definitions of credit events. The 1999 ISDA Credit Derivatives Definitions (referred to as the "1999 Definitions") provides a list of eight credit events.
(a) Name four of these eight credit events.
(b) What do these events attempt to capture?

Question 68

What can a CRT vehicle result in? Explain by commenting on the concern with the banking system.

Question 69

The long maturity of CLNs reflects the desire of investors to take a credit view for such a time period.

Question 70

Unlike a single-name credit default swap, the preferred settlement term for a basket default swap is cash settlement. Describe this cash settlement in terms of the termination value.

Question 71

By whom and for what reasons are credit derivatives used? Give an example.

Question 72

Describe a structured finance operating company (SFOC). Does an SFOC seek a true arbitrage?

Question 73

With the development of any market vehicle, there is the concern that market participants will understand the associated risks.

Question 74

Like a CDO, the manager of an SFOC can increase or decrease its leverage based on its expectation about factors that impact the return on its portfolio.

Question 75

A CDO is a security backed by a diversified pool of equity securities.

Question 76

The motivation in a balance sheet transaction is to transfer loans on a financial institution's balance sheet and obtain capital relief.