CDS Flashcards

1
Q

Credit risk

A

is dispersion in financial outcomes associated with the failure or potential failure of counterparty to fulfill its financial obligations.

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2
Q

Credit protection buyer In a CDS

A

the credit protection buyer pays a periodic premium on a predetermined notional amount in exchange for a contingent payment from the credit protection seller if a specified credit event occurs.

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3
Q

Credit protection seller

A

receives a periodic premium in exchange for delivering a contingent payment to the credit protection buyer if a specified credit event occurs.

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4
Q

CDS spread or CDS premium

A

is paid by the credit protection buyer to the credit protection seller and is quoted in basis points per annum on the notional value of the CDS.

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5
Q

Derivatives

A

are cost-effective vehicles for the transfer of risk, with values driven by an underlying asset.

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6
Q

Credit default swap (CDS)

A

is an insurance-like bilateral contract in which the buyer pays a periodic fee (analogous to an insurance premium) to the seller in exchange for a contingent payment from the seller if a credit event occurs with respect to an underlying credit-risky asset.

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7
Q

Physical settlement

A

requires the credit protection seller to purchase the impaired loan or bond from the credit protection buyer at par value.

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8
Q

Cash settlement

A

requires the credit protection seller to makes the credit protection buyer whole by transferring to the buyer an amount of cash based on the contract once a credit event has occurred.

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9
Q

Auction process

A

involves bidding among several private equity firms, with the deal going to the highest bidder.

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10
Q

Referenced asset

A

(also called the referenced bond, referenced obligation, or referenced credit) is the underlying security on which the credit protection is provided.

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11
Q

Standard ISDA agreement

A

serves as a template to negotiated credit agreements that contain commonly used provisions used by market participants.

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12
Q

Credit events that give rise to credit risk

A

include bankruptcy, downgrading, failure to make timely payments, certain corporate events, and government actions.

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13
Q

Acceleration

A

is a requirement that debt be repaid sooner than originally scheduled, such as when the senior lender can declare the senior debt due and payable immediately.

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14
Q

Notional principal

A

(or notional value) of a contract is the value of the asset underlying, or used as a reference to, the contract or derivative position.

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15
Q

Law of one price

A

states that, absent transaction and transportation costs, the same item should have the same price in all countries adjusted using current exchange rates.

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16
Q

Convergence

A

is the return of prices or rates to relative values that are deemed normal.

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17
Q

Zero sum game

A

is a market, environment, or situation in which any gains to one party must be
equally offset by losses to one or more other parties.

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18
Q

Market-making

A

is a practice whereby an investment bank or another market participant deals securities by regularly offering to buy securities and sell securities.

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19
Q

Total return swap

A

requires the credit protection buyer, typically the owner of the credit risky asset, to pass on the total return of the asset to the credit protection seller in return for a certain payment.

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20
Q

Mark-to-market adjustment

A

is the process of altering the value of a CDS in the accounting and financial systems of the CDS parties.

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21
Q

Novation or assignment

A

is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.

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22
Q

Credit events that give rise to credit risk

A

include bankruptcy, downgrading, failure to make timely payments, certain corporate events, and government actions.

23
Q

Reference portfolio

A

also known as the collateral, is the underlying portfolio or pool of assets (and/or derivatives) held in the SPV within the CDO structure.

24
Q

Senior tranche

A

is a tranche with the first or highest priority to cash flows in the structured product.

25
Q

Mezzanine tranche

A

is a tranche with a moderate priority to cash flows in the structured product and with lower priority than the senior tranche.

26
Q

Waterfall

A

is a provision of the limited partnership agreement that specifies how distributions from a fund will be split and how the payouts will be prioritized.

27
Q

Attachment point

A

also known as the lower attachment point, is the first percentage loss in the collateral pool that begins to cause reduction in the value of a tranche.

28
Q

Tranche

A

is a distinct claim on assets that differs substantially from other claims in such aspects as seniority, risk, and maturity.

29
Q

Upper attachment point

A

also known as the detachment point, is the higher loss point at which the given tranche is completely wiped out.

30
Q

Tranche width

A

is the percentage of the CDO’s capital structure that is attributable to a particular tranche.

31
Q

Structuring

A

is the process of engineering unique financial opportunities from existing asset exposures.

32
Q

Mortgage

A

is a loan secured by property.

33
Q

Mutual funds

A

are registered investment pools offering their shareholders pro rata claims on a fund’s portfolio of assets.

34
Q

Special purpose vehicle (SPV)

A

is a legal entity at the heart of a CDO structure that is established to accomplish a specific transaction, such as holding the collateral portfolio.

35
Q

Bankruptcy remote

A

means that if the sponsoring bank or money manager goes bankrupt, the CDO trust is not affected.

36
Q

Ramp-up period

A

is the first period in a CDO life cycle, during which the CDO trust issues securities (tranches) and uses the proceeds from the CDO note sale to acquire the initial collateral pool (the assets).

37
Q

Revolving period

A

is the second phase in the CDO life cycle, during which the manager of the CDO trust may actively manage the collateral pool for the CDO, potentially buying and selling securities and reinvesting the excess cash flows received from the CDO collateral pool.

38
Q

Weighted average rating factor (or WARF)

A

as described by Moody’s Investors Service, is a numerical scale ranging from 1 (for AAA-rated credit risks) to 10,000 (for the worst credit risks) that reflects the estimated probability of default.

39
Q

Probability of default (PD)

A

specifies the probability that the counterparty fails to meet its obligations.

40
Q

Diversity score

A

is a numerical estimation of the extent to which a portfolio is diversified.

41
Q

Balance sheet CDOs

A

are created to assist a financial institution in divesting assets from its balance sheet.

42
Q

Arbitrage CDOs

A

are created to attempt to exploit perceived opportunities to earn superior profits through active management.

43
Q

Cash-funded CDO

A

involves the actual purchase of the portfolio of securities serving as the collateral for the trust and to be held in the trust.

44
Q

Cash flow CDO

A

involves the proceeds of the issuance and sale of securities (tranches) that are used to purchase a portfolio of underlying credit-risky assets, with attention paid to matching the maturities of the assets and liabilities.

45
Q

Internal credit enhancement

A

is a mechanism that protects tranche investors and is made or exists within the CDO structure, such as a large cash position.

46
Q

Subordination

A

is the most common form of credit enhancement in a CDO transaction, which flows from the structure of the CDO trust.

47
Q

Overcollateralization

A

refers to the excess of assets over a given liability or group of liabilities.

48
Q

Reserve account

A

holds excess cash in highly rated instruments, such as U.S. Treasury securities
or high-grade commercial paper, to provide security to the debt holders of the CDO trust.

49
Q

External credit enhancement

A

is a protection to tranche investors that is provided by an outside third party, such as a form of insurance against defaults in the loan portfolio

50
Q

Investment bank

A

focuses on providing sophisticated investment services, including underwriting and raising capital, as well as other activities such as brokerage services, mergers, and acquisitions.

51
Q

Financial engineering risk

A

is the potential loss attributable to securitization, structuring of cash flows, option exposures, and other applications of innovative financing devices.v

52
Q

Securitization

A

involves bundling assets, especially unlisted assets, and issuing claims on the bundled assets.

53
Q

Copula approach to analyzing the credit risk of a CDO

A

may be viewed as a simulation analysis of the effects of possible default rates on the cash flows to the CDO’s tranches and the values of the CDO’s tranches.

54
Q

Assignment, or novation,

A

is when one party to a contract reaches an agreement with a third party to take over all rights and obligations to a contract.