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?

Question

Quizplus · 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.

A Financial Institution Plans to Issue a Group of Bonds