CAIA - 29 - Hedge Funds: Credit Strategies

Question 1

___ ___refers to an economic process in which undesirable outcomes occur when parties to a transaction have asymmetric information.

Answer 1

Adverse selection refers to an economic process in which undesirable outcomes occur when parties to a transaction have asymmetric information.

Question 2

___ ___occurs after an economic transaction is completed and arises when one party to a transaction changes its behavior and the other party bears the consequences.

Answer 2

Moral hazard occurs after an economic transaction is completed and arises when one party to a transaction changes its behavior and the other party bears the consequences.

Question 3

Recovery Rate Equation

Answer 3

PV of sum to be recovered / Exposure at Default (EAD)

Question 4

Loss Given Default (LGD) Equation

Answer 4

Exposure at Default (1 - Recovery Rate)

Question 5

Expected loss given credit risk equation

Answer 5

Loss Given Default (LGD) x Probability of Default (PD)

=

Exposure at Default (EAD) * (1 - Recovery Rate) * PD

Question 6

The ___ approach to modeling credit risk assumes an explicit relationship between a firm’s capital structure and default, and describes the value of a firm’s assets as being equal to the value of its equity plus the value of its debt.

Answer 6

The structural approach to modeling credit risk assumes an explicit relationship between a firm’s capital structure and default, and describes the value of a firm’s assets as being equal to the value of its equity plus the value of its debt.

Question 7

Under the structural approach, the firm’s equity is considered a ___ ___on its assets, with a strike price equal the face value of its ___due at ___date.

Answer 7

Under the structural approach, the firm’s equity is considered a call option on its assets, with a strike price equal the face value of its debt due at exercise date.

Question 8

The ___-___approach to modeling credit risk models default as an exogenous event driven by a random signal.

Answer 8

The reduced-form approach to modeling credit risk models default as an exogenous event driven by a random signal.

Question 9

The ___ approach to modeling credit risk involves examining the financial data of companies that have defaulted to try and understand their credit risk.

Answer 9

The empirical approach to modeling credit risk involves examining the financial data of companies that have defaulted to try and understand their credit risk.

Question 10

The best known structural credit risk model is the ___ model.

Answer 10

The best known structural credit risk model is the Merton model.

Question 11

Murton Model Equation

Answer 11

Assets = Debt + Equity

Question 12

The Murton Model assumes that default occurs at ___. It also assumes that ___is costless, ___and ___can be traded without friction and that debt is a ___-___bond.

Answer 12

The Murton Model assumes that default occurs at maturity. It also assumes that bankruptcy is costless, debt and equity can be traded without friction and that debt is a zero-coupon bond.

Question 13

Equity in a merton model equation

Answer 13

E = max(A - K, 0)

E = Equity

A = Assets

K = Strike

Question 14

Debt in a merton model equation

Answer 14

D = K - max(K - A, 0)

D = Debt

K = Strike

A = Assets

Question 15

Black-Scholes Option Pricing Model

Answer 15

Question 16

d = what in black scholes model

Answer 16

Question 17

Probability of Default in the Merton Model Equation

Answer 17

Question 18

Value of Zero Coupon Debt in Merton Model (equation)

Answer 18

Question 19

Spread in Merton Model (Equation)

Answer 19

Question 20

The primary advantage of the ___ model is that it has several intuitive properties and serves as a basis for more complex models.

Answer 20

The primary advantage of the Merton model is that it has several intuitive properties and serves as a basis for more complex models.

Question 21

The Merton model has several shortcomings:

1. It’s model’s parameters are not ___ ___
2. It is not successful as explaining the ___ ___ on ___-___ securities

Answer 21

The Merton model has several shortcomings:

1. It’s model’s parameters are not readily observable
2. It is not successful as explaining the credit spread on short-term securities

Question 22

The Merton model has four important properties:

1. Sensitivity to ___
2. Sensitivity to ___ ___
3. Sensitivity to ___
4. Sensitivity to ___ ___

Answer 22

The Merton model has four important properties:

1. Sensitivity to maturity
2. Sensitivity to asset volatility
3. Sensitivity to leverage
4. Sensitivity to riskless rate

Question 23

As time to maturity increases, the credit spread ___ initially, but then ___slightly.

Answer 23

As time to maturity increases, the credit spread increases initially, but then declines slightly.

Question 24

As asset volatility increase, the probability of default ___ and the credit spread ___.

Answer 24

As asset volatility increase, the probability of default increases and the credit spread increases.

Question 25

As leverage increases, the default probability ___ and the credit spread ___.

Answer 25

As leverage increases, the default probability increases and the credit spread increases.

Question 26

The ___ model is a structural credit risk model that estimates the credit risk of debt by considering the loan repayment incentive problem from the perspective of the borrowing firm’s equity holders.

Answer 26

The KMV model is a structural credit risk model that estimates the credit risk of debt by considering the loan repayment incentive problem from the perspective of the borrowing firm’s equity holders.

Question 27

The structural relationship between the MV of a firm’s equity and its assets under the KMV model (Equation)

Answer 27

Question 28

Relationship between volatility a firm’s assets and equity according to KMV model (equation)

Answer 28

Question 29

The ___ model’s default trigger is the face value of the zero coupon bond.

Answer 29

The merton model’s default trigger is the face value of the zero coupon bond.

Question 30

The ___ model’s default trigger is based on a weighted average of face values of short-term and long-term debt.

Answer 30

The KMV model’s default trigger is based on a weighted average of face values of short-term and long-term debt.

Question 31

The ___ to ___refers to the number of standard deviations that a firm’s assets must lose to decline in value to the default trigger.

Answer 31

The distance to default refers to the number of standard deviations that a firm’s assets must lose to decline in value to the default trigger.

Question 32

Distance to Default Equation

Answer 32

Question 33

The KMV model calculates the ___ ___ ___ empirically as the ratio of the percentage of firms in a database that defaulted within one year when their asset values placed them n standard deviations away from the default at the start of the year relative to the total population of firms that were n standard deviations away from default.

Answer 33

The KMV model calculates the expected default frequency empirically as the ratio of the percentage of firms in a database that defaulted within one year when their asset values placed them n standard deviations away from the default at the start of the year relative to the total population of firms that were n standard deviations away from default.

Question 34

Expected Default Frequency under KMV (Equation)

Answer 34

Question 35

The probability that a firm has survived for t years under the reduced-form model

Answer 35

Question 36

Probability that default takes place between s and t using reduced-form model

Answer 36

Question 37

Zero coupon value under reduced form model

Answer 37

Question 38

Zero coupon value under reduced form model with recovery rate

Answer 38

Question 39

Credit spread under reduced form model

Answer 39

Question 40

The ___ ___reduced-form credit model assumes that recovery is received at the maturity date.

Answer 40

The Jarrow Turnbull reduced-form credit model assumes that recovery is received at the maturity date.

Question 41

The ___-___ reduced-form credit model allows the recovery process to occur at any time and sets the recovery amount to a fraction of the non-defaulting bond price at the time of the default.

Answer 41

The Duffie-Singleton reduced-form credit model allows the recovery process to occur at any time and sets the recovery amount to a fraction of the non-defaulting bond price at the time of the default.

Question 42

In practice, ___ credit models are best suited to fundamental security analysis and ___-___ credit models are used in fast-moving environments.

Answer 42

In practice, structural credit models are best suited to fundamental security analysis and reduced-form credit models are used in fast-moving environments.

Question 43

The advantages of the ___ model is that it links credit risk to the company’s fundamentals, explicitly accounts for the borrower’s capital structure and allows for the valuation of debt.

Answer 43

The advantages of the structural model is that it links credit risk to the company’s fundamentals, explicitly accounts for the borrower’s capital structure and allows for the valuation of debt.

Question 44

The disadvantages of the ___ model is that it assumes the firm’s asset values are known and assumes continuity tradability for corporate debt.

Answer 44

The disadvantages of the Merton model is that it assumes the firm’s asset values are known and assumes continuity tradability for corporate debt.

Question 45

The disadvantages of the KMV model are:

1. Depends on availability of ___ ___ ___
2. Assumes ___ ___ of default frequency
3. Does not account for ___ ___ of debt
4. Assumes ___ capital structure.

Answer 45

The disadvantages of the KMV model are:

1. Depends on availability of publicly traded equity
2. Assumes normal distribution of default frequency
3. Does not account for all features of debt
4. Assumes static capital structure.

Question 46

The advantage of the ___-___ credit model is that they are flexible and easier to implement and calibrate.

Answer 46

The advantage of the reduced-form credit model is that they are flexible and easier to implement and calibrate.

Question 47

The disadvantage of the ___-___ model is that they do not provide insight into the link between default and drivers of credit worthiness.

Answer 47

The disadvantage of the reduced-form model is that they do not provide insight into the link between default and drivers of credit worthiness.

Question 48

Empirical credit models differ from the reduced-form in 2 key ways:

1. They use ___ default data
2. They do not estimate the ___of ___or ___ ___.

Answer 48

Empirical credit models differ from the reduced-form in 2 key ways:

1. They use historical default data
2. They do not estimate the probability of default or credit spread.

Question 49

The goal of empirical credit models is to generate a ___ ___that may be used to rank the riskiness of firms or securities.

Answer 49

The goal of empirical credit models is to generate a credit score that may be used to rank the riskiness of firms or securities.

Question 50

___ ___-___ model is an econometric credit scoring model based on five financial ratios that can be used to predict financial stress

Answer 50

Altman’s z-score model is an econometric credit scoring model based on five financial ratios that can be used to predict financial stress

Question 51

Altman’s Z-Score Equation

Answer 51

Question 52

The ___ ___/ ___ ___ratio measures a firm’s net liquid assets

Answer 52

The working capital / total assets ratio measures a firm’s net liquid assets

Question 53

The ___ ___/ ___ ___ratio measures the relative size of the total amount of reinvested earnings over a firm’s entire life.

Answer 53

The retained earnings / total assets ratio measures the relative size of the total amount of reinvested earnings over a firm’s entire life.

Question 54

___ / ___ ___ measures the productivity of a firm’s assets

Answer 54

EBIT / Total Assets measures the productivity of a firm’s assets

Question 55

___ of ___/ ___of ___represents the amount a firm’s assets can decline in value before the firm becomes insolvent.

Answer 55

MV of Equity / BV of LIabilities represents the amount a firm’s assets can decline in value before the firm becomes insolvent.

Question 56

___ / ___ ___ measures the ability of a firm’s assets to generate sales.

Answer 56

Sales / Total assets measures the ability of a firm’s assets to generate sales.

Question 57

3 zones for altman z-score

Answer 57

Question 58

___ default occurs when a borrower is in breach of its loan obligations’ covenants.

Answer 58

Technical default occurs when a borrower is in breach of its loan obligations’ covenants.

Question 59

___ default occurs when a firm fails to make required interest or principal payments.

Answer 59

Actual default occurs when a firm fails to make required interest or principal payments.

Question 60

___ ___are made by vendors that provide goods and services to distressed borrowing firms.

Answer 60

Trade claims are made by vendors that provide goods and services to distressed borrowing firms.

Question 61

Distressed debt is typically rated ___ or below.

Answer 61

Distressed debt is typically rated D or below.

Question 62

Distressed corporate bonds typically trade with a spread greater than ___% to comparable treasury bonds.

Answer 62

Distressed corporate bonds typically trade with a spread greater than 10% to comparable treasury bonds.

Question 63

A bank loan trading at a price of ___% of par value and a bond trading at a price of ___% of par value are typically considered distressed.

Answer 63

A bank loan trading at a price of 80% of par value and a bond trading at a price of 40% of par value are typically considered distressed.

Question 64

A ___ ___is classified as default that occurs when a borrower repurchases a creditor’s claim for cash.

Answer 64

A distressed exchange is classified as default that occurs when a borrower repurchases a creditor’s claim for cash.

Question 65

An ___ ___is classified as default that occurs when a borrower exchanges the original obligation for a new instrument.

Answer 65

An exchange offer is classified as default that occurs when a borrower exchanges the original obligation for a new instrument.

Question 66

Business-related issues often require ___ ___.

Answer 66

Business-related issues often require operational restructuring.

Question 67

When a company ___ ___ ___ it extends the maturity of existing debt.

Answer 67

When a company terms out debt it extends the maturity of existing debt.

Question 68

What are the 2 restructuring options for distressed companies:

1.

2.

Answer 68

What are the 2 restructuring options for distressed companies:

1. File for Bankruptcy

2. Out-of-Court Restructuring

Question 69

An out of court restructuring may include an ___ ___ that provides the company with enhanced flexibility like access to additional debt or liquidity.

Answer 69

An out of court restructuring may include an accordian feature that provides the company with enhanced flexibility like access to additional debt or liquidity.

Question 70

U.S. bankruptcy filing typically involves two sections in the U.S. Bankruptcy Code: 1) Chapter ___, which governs restructuring and 2) Chapter ___, which governs liquidation.

Answer 70

U.S. bankruptcy filing typically involves two sections in the U.S. Bankruptcy Code: 1) Chapter 11, which governs restructuring and 2) Chapter 7, which governs liquidation.

Question 71

Once a debtor files for bankruptcy, it becomes known as the ___-___-___.

Answer 71

Once a debtor files for bankruptcy, it becomes known as the debtor-in-possession.

Question 72

___ ___, with a ___of ___that has already been distributed to and voted on by the creditor class reduces the time and cost of bankruptcy process considerably.

Answer 72

Prepackaged filings, with a plan of reorganization that has already been distributed to and voted on by the creditor class reduces the time and cost of bankruptcy process considerably.

Question 73

Under the 2005 BAPCPA, debtors-in-possession have ___ months to propose a plan of reorganization and ___more months for the solicitation of a vote.

Answer 73

Under the 2005 BAPCPA, debtors-in-possession have 18 months to propose a plan of reorganization and 20 more months for the solicitation of a vote.

Question 74

A bankruptcy court (can/can not) impose a plan of reorganization on creditors.

Answer 74

A bankruptcy court can impose a plan of reorganization on creditors.

As long as it is fair and equitable

Question 75

The UK is considered (creditor/debtor) friendly.

Answer 75

The UK is considered creditor friendly.

Question 76

A ___ of ___(UK) is a court-sanctioned restructuring process that enables reorganization of solvent and insolvent companies. It needs to be approved by ___% of the impacted classes and ___% of each class of creditors.

Answer 76

A scheme of arrangement (UK) is a court-sanctioned restructuring process that enables reorganization of solvent and insolvent companies. It needs to be approved by a 50% of the impacted classes and 75% of each class of creditors.

Question 77

An ___ of ___(UK) transfers the debtor’s control to an administrator and is intended to restructure insolvent companies.

Answer 77

An administration of restructuring (UK) transfers the debtor’s control to an administrator and is intended to restructure insolvent companies.

Question 78

In general, UK bankruptcy laws are moving (closer to/further from) U.S. Chapter 11 rules that aim to save companies from liquidating.

Answer 78

In general, UK bankruptcy laws are moving closer to U.S. Chapter 11 rules that aim to save companies from liquidating.

Question 79

In France, the ___ typically take priority during a restructuring.

Answer 79

In France, the workers typically take priority during a restructuring.

Question 80

Outside of the U.S. and Europe, bankruptcy laws (are/are not) well developed.

Answer 80

Outside of the U.S. and Europe, bankruptcy laws are not well developed.

Question 81

The ___-to-___approach can be considered a relatively hostile strategy that involves an investor providing a loan to a company and ultimately taking control.

Answer 81

The loan-to-own approach can be considered a relatively hostile strategy that involves an investor providing a loan to a company and ultimately taking control.

Question 82

The ___ distressed investing strategy involves an investor buying a distressed borrower’s bond or loan, holding the instrument through workout/bankruptcy, swapping part or all of the debt claims for the reorganized entity’s equity, and exiting via sale to a strategic buyer or the public market via an initial public offering.

Answer 82

The classic distressed investing strategy involves an investor buying a distressed borrower’s bond or loan, holding the instrument through workout/bankruptcy, swapping part or all of the debt claims for the reorganized entity’s equity, and exiting via sale to a strategic buyer or the public market via an initial public offering.

Question 83

The ___-oriented distressed strategy is a non-control-oriented strategy that aims to capture the excess premium in debt instruments that are oversold when non-economic sellers liquidate their holdings.

Answer 83

The trading-oriented distressed strategy is a non-control-oriented strategy that aims to capture the excess premium in debt instruments that are oversold when non-economic sellers liquidate their holdings.

Question 84

Trading oriented distressed strategies are best suited to ___ restructurings with ___buyers and sellers.

Answer 84

Trading oriented distressed strategies are best suited to large restructurings with several buyers and sellers.

Question 85

DIP loans have a ___ coupon rate and are issued at a ___to par. They also have ___-___status.

Answer 85

DIP loans have a higher coupon rate and are issued at a discount to par. They also have super-seniority status.

Question 86

An ___-___ ___ is a secured loan backed by different types of collateral pledged by a borrower.

Answer 86

An asset-based loan is a secured loan backed by different types of collateral pledged by a borrower.

Question 87

ABL lenders use a ___ ___to determine the amount of credit to extend to a borrower.

Answer 87

ABL lenders use a borrowing base to determine the amount of credit to extend to a borrower.

Question 88

The type of eligible collateral and the assets in the collateral package determine the ___ ___, which is the ratio of credit for every dollar of collateral.

Answer 88

The type of eligible collateral and the assets in the collateral package determine the advance rate, which is the ratio of credit for every dollar of collateral.

Question 89

A ___ ___temporarily provides a higher advance rate to account for seasonal effects when borrowers need more working capital.

Answer 89

A seasonal overadvance temporarily provides a higher advance rate to account for seasonal effects when borrowers need more working capital.

Question 90

Advance rates on typical accounts receivable are ___-___%

Answer 90

Advance rates on typical accounts receivable are 75-85%

Question 91

A ___ ___provides a higher advance rate, where the additional borrowing is amortized over several years.

Answer 91

A traditional overadvance provides a higher advance rate, where the additional borrowing is amortized over several years.

Question 92

___ overadvances are typically used with corporate acquisitions or leveraged buyouts.

Answer 92

Traditional overadvances are typically used with corporate acquisitions or leveraged buyouts.

Question 93

Smaller and midsize borrowers use ABLs (more/less) extensively in their capital structure.

Answer 93

Smaller and midsize borrowers use ABLs more extensively in their capital structure.

Question 94

Typical ABL credit facilities are composed of a ___ ___or a ___.

Answer 94

Typical ABL credit facilities are composed of a term loan or a revolver.

Question 95

A ___ ___is secured against long-term assets and has an amortizing or a bullet structure.

Answer 95

A term loan is secured against long-term assets and has an amortizing or a bullet structure.

Question 96

A term loan typically makes up ___% or less of the total ABL facility.

Answer 96

A term loan typically makes up 33% or less of the total ABL facility.

Question 97

A ___ is a credit line with a preapproved limit available for a specific time period.

Answer 97

A revolver is a credit line with a preapproved limit available for a specific time period.

Question 98

ABLs (do/do not) typically have leverage covenants.

Answer 98

ABLs do not typically have leverage covenants.

Question 99

ABL lenders typically use the ___ ___ ___ credit metric.

Answer 99

ABL lenders typically use the fixed charge coverage credit metric.

Question 100

Fixed Charge Coverage Ratio (equation)

Answer 100

Question 101

In some ABL facilities, the fixed charge covenant is a ___ covenant, that is, it is not effective until the borrower’s unused loan capacity falls below a certain level.

Answer 101

In some ABL facilities, the fixed charge covenant is a springing covenant, that is, it is not effective until the borrower’s unused loan capacity falls below a certain level.

Question 102

Asset Based Lending Strategies face the following unique risks:

1. V
2. P
3. H
4. L
5. T

Answer 102

Asset Based Lending Strategies face the following unique risks:

1. Valuation
2. Process and people
3. Hedging
4. Legal
5. Timing