Deck 29: Credit Derivative Products

Question 1

Which of the following statements is valid?

A)A seller of credit risk is a buyer of credit protection.
B)A seller of credit risk is an issuer of credit protection.
C)A buyer of credit risk is a buyer of credit protection.
D)None of the above.

Answer 1

A
A seller of credit risk is reducing credit risk,i.e. ,is buying protection.

Question 2

Bank A is able to raise funds at Libor + 10 bps.Bank B does so at Libor + 40 bps.Bank A buys a credit risky asset returning Libor + 100 bps,and then A and B enter into a total return swap (TRS)where A pays B the total return on the asset in return for Libor + $y$ bps.What range of basis points $y$ would be acceptable to both parties in the contract?

A) $y < 100$
B) $y > 10$
C) $40 < y < 60$
D) $10 < y < 40$

Answer 2

$10 < y < 40$

Question 3

If you are interested in speculating on a deterioration in the credit quality of a company,which of the following would be appropriate?

A)Buy the bonds of the company.
B)Short the forwards on the credit spread of the company.
C)Buy credit spread call options on the company's bonds (i.e. ,options that pay off if the spread widens).
D)Sell put options on the company's bonds.

Answer 3

C
All the other answers are the opposite of what is intended,and are bets on the improvement in credit quality of the company.

Question 4

Which of the following credit derivatives is not a pure credit risk instrument,i.e. ,is a bet on more than just credit risk?

A)Credit spread forwards.
B)Credit spread options.
C)Total return swap.
D)Credit default swap.

Question 5

A digital default swap is a contract that is distinct from a credit default swap in that

A)It pays nothing is no credit event occurs.
B)It pays a fixed amount if a credit event occurs.
C)It has a single premium upfront instead of periodic premium payments.
D)Premium payments are only due if a credit event occurs.

Question 6

Bank A has a funding cost of $L + 10$ basis points,where $L$ is Libor.Bank B has funding cost of $L + 80$ basis points.There is a reference obligation currently yielding $L + 140$ basis points.In a "Funding Cost Arbitrage," Bank A pays B the total return on the reference obligation in exchange for a payment of $L + x$ basis points by Bank B,where:

A)The value of $x$
Must lie between 10 and 60
B)The value of $x$
Must lie between 10 and 80
C)The value of $x$
Must lie between 60 and 140
D)The value of $x$
Must lie between 80 and 140

Question 7

Which of the following is not a property or benefit of credit derivatives?

A)In instruments subject to multiple sources of risk (such as junk bonds),they enable separating out credit risk from other risks.
B)They enable hedging out credit risk of securities that are illiquid and hard to sell.
C)They reduce the overall level of default risk in the economy.
D)They offer reference prices that make it easier to price other securities that have credit risk.

Question 8

Suppose that an investor has purchased $250 million of protection on the iTraxx Europe which is an equally-weighted index composed of 125 European investment-grade names.If one of the names in the index were to default,the protection seller compensates the buyer for the loss-given-default on that name on a notional of _________________,the index continue to trade on _______________ names;and all subsequent premium payments are based on a notional of______________.

A)1 million;125;250 million
B)2 million;125;248 million
C)2 million;124;250 milliion
D)2 million;124;248 million

Question 9

Total return swaps (TRSs)are sometimes undertaken between banks who can access an asset on-balance-sheet and funds that lack access to,or are not allowed to,hold the asset.In such a situation,

A)The bank is using the TRS to enhance its credit exposure to the underlying asset.
B)The fund is making the bank assume risk that it does not itself wish to assume.
C)The bank is enhancing its return at the expense of the fund.
D)The bank is effectively lending the use of its balance sheet to the fund.

Question 10

A collateralized default obligation (CDO)is a pool of securities (collateral)whose cash flows are tranched and sold to investors who take different levels of credit loss in the portfolio.Which of the following is the least likely to be seen in a the collateral of a CDO.

A)A portfolio of equities.
B)A portfolio of bonds.
C)A portfolio of CDS.
D)A portfolio of CDOs.

Question 11

Bank A holds a credit risky asset on its balance sheet.It enters into a total return swap (TRS)referenced to this asset with hedge fund B to pay the total return to B and receive Libor in return.Under what scenario does bank A bear credit risk on the reference asset this contract?

A)When the issuer of the reference asset defaults.
B)When hedge fund B defaults.
C)Only when the issuer of the reference asset and hedge fund B default.
D)All of the above.

Question 12

A first Ðto-default (FTD)basket pays off when the first default occurs in the given basket of "names." The spread on a first-to-default basket is:

A)At least the narrowest credit spread of all the names in the basket and at most the widest credit spread of all the names in the basket.
B)Equal to the average credit spread across all the names in the basket.
C)At least the widest credit spread of all the names in the basket and at most the sum of the credit spreads across all the names in the basket.
D)Equal to the widest credit spread of all the names in the basket.

Question 13

Today,investor A buys protection on a first-to-default basket,while investor B buys protection via Credit Default Swaps on each individual name in that basket.All contracts have the same maturity.Suppose that at maturity,it turns out that only one name out of the basket has defaulted then,

A)Investor As strategy has been at least as profitable as that of investor B
B)Investor Bs strategy has been at least as profitable as that of investor A
C)Both strategies have been equally profitable
D)The answer depends on the spread of the defaulted name

Question 14

Which of the following factors contributed to the the substantial growth in the market for credit derivatives in the 2000s?

A)Extensive growth in debt markets.
B)Disintermediation of banks.
C)Increases in regulation of securities markets,investors,and issuers.
D)All of the above.

Question 15

A settlement squeeze in the credit default swap market is least likely to occur when the CDS contracts are

A)Settled by delivery of the defaulted reference security in exchange for par value in cash.
B)Settled by delivery of the defaulted reference security in exchange for the initial value of the security (at swap inception)in cash.
C)Settled by delivery of the defaulted reference security in exchange for a fixed sum of money.
D)Cash settled.

Question 16

Which of the following is not one of the three "C"s of lending in banking?

A)Character.
B)Collateral.
C)Conscientiousness.
D)Capacity to repay.

Question 17

CDS settlement is not likely to be triggered by which of the following events?

A)A restructuring of the company.
B)A secondary equity offering by the company.
C)Failure to make interest payments on bonds of the company.
D)The company repudiates its debt.

Question 18

In a typical Credit Linked Note structure,a special-purpose vehicle (SPV)issues notes tied to the credit performance of a reference obligation.Buyers of these notes are protection on the reference obligation and are the risk of the SPV mismanaging the collateral

A)Buying,Taking on
B)Buying;Not taking on
C)Selling;Taking on
D)Selling;Not taking on

Question 19

Credit risk in bonds involves uncertainty about whether the bond will default (default risk),and uncertainty about the value of the bonds when they default (recovery risk).In order to profit from a view that recovery risk will worsen,you would

A)Buy a credit default swap (CDS)and sell a digital default swap (DDS).
B)Sell a credit default swap (CDS)and buy a digital default swap (DDS).
C)Buy a credit default swap (CDS)and buy a digital default swap (DDS).
D)Sell a credit default swap (CDS)and sell a digital default swap (DDS).

Question 20

Consider a total return swap (on a credit-risky bond)of total returns against Libor.The receiver of total return in this swap has a position that is equivalent to

A)A forward contract to buy the asset at a fixed price at maturity of the swap.
B)A long position in the asset and short position in a floating-rate note.
C)A short position in the asset and long position in a floating-rate note.
D)An asset swap that delivers the asset in exchange for a floating-rate note.

Question 21

A $100 million CDO has tranches running from loss ranges of: 0-3%,3-7%,7-10%,10-15%,and greater than 15%.The 7-10% tranche may be stated equivalently as

A)A long call on the CDO collateral at strike $10 million and a short call on the CDO collateral at strike $7 million.
B)A long put on the CDO collateral at strike $10 million and a short put on the CDO collateral at strike $7 million.
C)The value of the $3 million tranche plus a call spread consisting of a short call on losses at the 7% strike level and a long call at the 10% strike level.
D)The value of the $3 million tranche minus a call spread consisting of a short call on losses at the 7% strike level and a long call at the 10% strike level.

Question 22

The CDS-Bond basis is the difference in credit spreads in the CDS and bond markets,i.e. ,CDS spread minus the bond spread.Which of the following scenarios will make the basis greater,i.e. ,move it in the positive direction?

A)The bond market becomes illiquid relative to the CDS market.
B)The demand for convertible bonds increases,as does the need to hedge the credit risk in these bonds.
C)The market for synthetic CDOs heats up.
D)The bond price moves down sharply.

Question 23

The asset swap spread is

A)The spread of the fixed rate over current Libor in an interest-rate swap.
B)The spread over Libor on the floating leg of a swap to exchange the return from a commodity for a floating rate.
C)The spread over Libor on the floating leg of an interest-rate swap combined with a fixed coupon asset,such that the package is at par.
D)The spread over Libor on the floating leg of an interest-rate swap combined with a credit default swap,such that the package is at zero value.

Question 24

What action is involved in constructing a synthetic CDO?

A)Selling protection via CDS contracts.
B)Buying protection via CDS conracts.
C)Selling tranches of other CDOs.
D)Buying a diversified equity portfolio.

Question 25

A first-to-default (FTD)basket option pays off when any one of the companies in a credit basket defaults.The price of the FTD basket decreases when

A)The credit quality of any issuer in the basket declines.
B)The correlation of default across names in the basket increases.
C)The correlation of default across names in the basket decreases.
D)The volatility of credit spreads for names in the basket increases.

Question 26

Assume that the CDX-iTraxx index has 125 names in it,for a total notional of $100,000,000.If the recovery rate on default of any name is 40%,at least how many names must default for the 3-7% tranche of the CDO to be wiped out?

A)7
B)8
C)15
D)23

Question 27

The "base" correlation in a CDO is

A)The lowest correlation implied across all the tranches of the CDO.
B)The correlation required to match the value of the collateral of the CDO.
C)The average correlation of all implied tranche correlations.
D)The correlation required to match total losses from the equity tranche to any particular loss tranche.

Question 28

Suppose an investor wishes to sell protection on $10 million of the CDX Index where the fixed spread is 100 bps.If the current spread on the index is 150 bps,then the investor will receive

A)The risky present value of 150 bps taken over the life of the contract as an upfront payment at inception.
B)The risky present value of 50 bps taken over the life of the contract as an upfront payment at inception plus a running quarterly premium of $25,000.
C)The risky present value of 50 bps taken over the life of the contract as an upfront premium at inception plus a running quarterly premium of $100,000.
D)The risky present value of 50 bps taken over the life of the contract as an upfront payment at inception plus a running quarterly premium of $150,000.

Question 29

Credit risk in bonds involves uncertainty about whether the bond will default (default risk),and uncertainty about the value of the bonds when they default (recovery risk).In order to profit from a view that default risk will worsen,while not taking a view on recovery risk,you would most prefer to

A)Buy a credit default swap (CDS)and sell a digital default swap (DDS).
B)Sell a credit default swap (CDS)and buy a digital default swap (DDS).
C)Sell a credit default swap (CDS).
D)Buy a digital default swap (DDS).

Question 30

The fair price of a CDS contract on a reference bond is equivalent to that of a spread on a floating-rate bond issued by the same entity as the reference bond and that

A)Is trading at par.
B)Has the same maturity as the CDS.
C)Has the same seniority as the reference bond underlying the CDS.
D)Has all three properties listed above.

Question 31

Bank A is able to raise funds at Libor.Bank B does so at Libor + 30 bps.Bank A buys a reference credit risky asset returning Libor + 70 bps,and then,A and B contract with each other on a credit swap (CDS)where A buys protection on the reference asset from B for $y$ bps.What range of basis points $y$ would be acceptable to both parties in the contract?

A) $y < 70$
B) $y > 40$
C) $40 < y < 70$
D) $10 < y < 40$

Question 32

A credit-sensitive note (CSN)has a coupon that is indexed to the credit rating of the issuer.When the credit rating worsens,CSNs pay a higher rate of interest and when the rating improves they pay a lower rate.Which of the following is the most valid?

A)The risk in these bonds is that they promise to pay a higher coupon when the company's ability to pay is the weakest.
B)The CSN has more risk for the investor than a fixed-coupon bond of the same issuer because the coupons are volatile.
C)Issuers of CSNs prefer to issue these bonds when their ratings are high.
D)CSNs are expensive because they require the issuer to re-rate its bonds more frequently and thereby incur additional costs.