Chap 23 Introduction to Structuring

Question 1

Similarity between capital structure of an operating firm and a structured product

Answer 1

Both are used to structure risk (and longevity).

Capital structure:
structure risk in business enterprise

Structured product:
structure risk in a financial portfolio

Question 2

Primary role of structuring in economy

Answer 2

Market completion

Making available a broader spectrum of investment opportunities

Question 3

How could a financial market become less ocmplete

Answer 3

By having a reduction in the number of unique investment opportunities or an increase in the number of uncertainties facing investor

Question 4

As an investor, what’s the difference between owning a tranche in a sequential-pay CMO vs a targeted amortization class CMO in a rising interest rate environment

CMO - collateralized mortgage obligation

Answer 4

Sequential-pay CMO:
the order/prepayment does not change, the senior most tranche is paid first and so on

Targeted amortization class CMO:
receive payments in accordance with a more complex priority that changes with major changes in prepayment speeds such that various tranches may experiences substantial increase/decrease in seniority in receiving cash distribution

Question 5

Extension risk and contraction risk of the principal-only tranche to a CMO?

Answer 5

Principal-only tranches are positively exposed to extension risk (values decline when their payments extend in longevity, prepayments slow) since PO holders receive no coupons.

Negatively exposed to contraction risk, as interest rates decline, the speed of prepayments increase and value increase

Question 6

Two types of investor motivation to invest in a tranche of CMO rather than investing directly in mortgages similar to the ones in CMO’s collateral pool?

Answer 6

Risk management (e.g. through selecting tranches with specific longevity)

Return enhancement through better view of the market

Question 7

Two prominent time periods when structured mortgage products are believed to have increased systemic risk, difference between the underlying economic events

Answer 7

1994 & 2007

1994
extended maturities and higher interests caused market value of CMO to collapse, based more on interest rate risk rather than default risk

2007
creditworthiness dropped

negative cycle when investors liquidate their positions

Question 8

Merton’s structural model how is debt with default risk viewed as having exposure to a put option

Answer 8

Risky debt of a levered firm = owning a riskless bond and exchanging it for debt

debt of levered firm = Riskless bond - put option on firm’s asset

Question 9

Merton’s structural model
what is conflict of interest between stockholders and debt holders with regard to asset risk and how does this conflict relate to structured products

Answer 9

Optimal level of risk for the firm’s asset

Stockholders: long position in a call option prefer higher levels of risk, esp when the value of the firm’s assets is near or below the face value of the debt

Debt holders: prefer lower risks and reduced asset volatility, short position in a put option

manager can transfer wealth from debt holders to stock holders by increasing risk of firm’s assets (VC)

the conflict of interest is analogous to the case of structured products with multiple tranches. high level asset risk –> benefit junior tranche holders at the expense of senior tranche holders

Question 10

Three option strategies that resemble the ownership of a mezzanine tranche

Answer 10

a collar position
a bull call spread
a bull put spread