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 is equivalent to 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. This is because the losses in the 7-10% range are covered by the $3 million tranche, and the call spread captures additional upside potential in that range. Therefore, the correct answer is C.

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

The answer of The CDS-Bond basis is the difference in...

Question 3

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 4

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 is effectively receiving over the life of the contract. This difference is typically paid as an upfront premium (the risky present value of the 50 bps difference). Additionally, the investor receives a running quarterly premium based on the fixed spread of 100 bps on $10 million, which is $25,000 per quarter ($10,000,000 * 0.01 / 4).

Question 5

The "base" correlation in a CDO is

Accepted Answer

The "base" correlation in a CDO is the correlation required to match total losses from the equity tranche to any particular loss tranche. This is important because it allows investors to determine the appropriate risk associated with each tranche and make informed investment decisions. The other options are not accurate representations of the base correlation.

Question 6

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 Bank A, the cost of funds is Libor, and it earns Libor + 70 bps on the reference asset. To ensure a profit, A would want to pay less than 70 bps for the CDS. For Bank B, the cost of funds is Libor + 30 bps. To make a profit from the CDS, B would need to receive more than 30 bps. Therefore, both parties would find a range of $40 < y < 70$ bps acceptable.

Question 7

What action is involved in constructing a synthetic CDO?

Accepted Answer

Selling protection via CDS contracts is involved in constructing a synthetic CDO, as it allows investors to speculate on or hedge against the credit risk of a portfolio of assets without owning those assets directly.

Question 8

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

All three properties listed above are important in determining the fair price of a CDS contract. A spread on a floating-rate bond issued by the same entity as the reference bond with the same seniority and maturity as the CDS contract and trading at par provides a good benchmark for the fair price of the CDS contract. Therefore, option D is the best choice as it includes all three properties.

Question 9

The asset swap spread is

Accepted Answer

The asset swap spread refers to 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. This spread reflects the market's view of the creditworthiness of the fixed-rate bond issuer relative to the benchmark Libor rate. Option A is incorrect because it describes a regular interest-rate swap spread. Option B refers to a commodity swap, which is not relevant to the asset swap spread. Option D refers to a combination of interest-rate and credit default swaps, which is not directly related to the asset swap spread.

Question 10

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 of the CDO is worth $3,000,000. If the recovery rate on default of any name is 40%, then the total loss on default of a name is $60,000,000. Therefore, at least 15 names must default for the 3-7% tranche of the CDO to be wiped out.

Quiz 29: Credit Derivative Products