Question 1

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

Accepted Answer

The 7-10% tranche can be decomposed into the $3 million tranche and a call spread. The call spread consists of a short call on losses at the 7% strike level and a long call at the 10% strike level. This is because if losses are between 7% and 10%, the $3 million tranche will not incur losses, but the call spread will have a positive value. Therefore, the value of the 7-10% tranche is equal to the value of the $3 million tranche plus the call spread.

Question 2

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?

Accepted Answer

When hedging demands increase as more buyers seek protection through CDS,the price (spread)on CDS increases.In contrast,for answer (a),when the bond market becomes illiquid,bond spreads increase.For (c)when the market for synthetic CDOs heats up,more CDS is issued,and the CDS spread falls.In (d),when the bond goes off the run,a higher spread is required to induce investors to buy the bond as it turns illiquid.

Question 3

The asset swap spread is

Accepted Answer

See the description in Chapter 31 for details.

Question 4

What action is involved in constructing a synthetic CDO?

Accepted Answer

Selling protection via CDS contracts is involved in constructing a synthetic CDO. This involves creating a portfolio of credit default swaps (CDS) to mimic the performance of a CDO, allowing investors to speculate on or hedge against credit risk without owning the actual securities.

Question 5

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

Accepted Answer

is also not applicable.

Question 6

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?

Accepted Answer

The 3-7% tranche covers losses from 3% to 7% of the total notional. The total notional is $100,000,000, so the tranche covers $4,000,000 ($100,000,000 * 4%). With a recovery rate of 40%, the loss per defaulted name is 60% of $800,000 (the notional per name), which is $480,000. To wipe out the tranche, $4,000,000 / $480,000 = 8.33, so at least 9 names must default. However, since the question asks for the minimum number of defaults to wipe out the tranche, and considering the tranche starts at 3%, we need to account for the first 3% ($3,000,000) being absorbed by the equity tranche. Therefore, 15 defaults are needed to reach the 7% loss level.

Question 7

The "base" correlation in a CDO is

Accepted Answer

The base correlation of the 0-3% equity tranche is the same as its implied correlation.The base correlation of the 3-7% tranche is the correlation required to match the combined value of the 0-3% and 3-7% tranches.The base correlation of the 7-10% tranche is the correlation required to match the combined value of the 0-3%,3-7% tranches,and 7-10% tranches.And so on.

Question 8

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

Accepted Answer

The investor is selling protection at a fixed spread of 100 bps while the current spread is 150 bps. The difference of 50 bps represents the additional spread the investor will receive over the life of the contract. This is typically received as an upfront payment calculated as the present value of the difference over the contract's life. Additionally, the fixed spread of 100 bps on $10 million equates to an annual payment of $100,000, or $25,000 quarterly.

Question 9

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

Accepted Answer

The answer of Credit risk in bonds involves uncertainty about...

Question 10

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

Accepted Answer

The fair price of a CDS contract on a reference bond is based on the spread of a floating-rate bond issued by the same entity as the reference bond, with the same maturity and seniority, and trading at par. Therefore, the correct choice is D, which includes all three properties listed above.

Question 11

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?

Accepted Answer

For the contract to be acceptable to both parties, Bank A would want to pay less than the 70 bps it earns from the reference asset, and Bank B would want to receive more than the 30 bps it costs them over Libor to raise funds. Therefore, $y$ must be greater than 30 bps but less than 70 bps, making $40 < y < 70$ the correct range.

Question 12

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?

Accepted Answer

is the only valid one.

Quiz 29: Credit Derivative Products