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CAS Exam 9 > Coval > Flashcards

Coval Flashcards

1
Q

Structured finance security

Coval

A

pooling of economic assets (e.g. loans, bonds, and mortgages) and issuance of a prioritized capital structure of claims, or tranches, against these pools

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2
Q

Collateralized debt obligation (CDO)

Coval

A

prototypical structured finance security that uses tranches to prioritize payments with the most junior tranches absorbing losses first, working up to the most senior tranches

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3
Q

Purpose of CDOs and credit-ratings of senior tranches

Coval

A

differing tranche priorities enables CDOs to convert underlying assets with high credit risk into highly-rated investment vehicles (credit rating of senior tranches is > average credit rating of underlying assets)

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4
Q

Goal of structured finance

Coval

A

create as many senior tranches as possible with higher credit ratings than the average rating of securities in the pool

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5
Q

Problem with structured finance/CDO securities

Coval

A

high ratings are extremely sensitive to assumptions regarding underlying assets such as default probabilities, correlations, and recovery rates

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6
Q

Correlation and relative safety of the most senior tranches

Coval

A

lower correlation means relatively “safer” senior tranches

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7
Q

Overcollateralization of CDOs

Coval

A

degree of protection offered by the more junior tranches

more protection > higher rating of senior tranche

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8
Q

Notional value of CDO

Coval

A

total potential bond payout (payments are made if bonds do not default)

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9
Q

Default for junior and senior tranches

Coval

A

junior tranches default if at least 1 bond defaults

senior tranches only default if all bonds default

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10
Q

Probability that one, both, and neither bond default in a 2-bond CDO structure

(Coval)

A

P(NN) = no bond defaults
= (1 - prob. default)^2 + rho * prob. default * (1 - prob. default)

P(DD) = both bonds default
= prob. default^2 + rho * prob. default * (1 - prob. default)

P(ND) = prob. 1 bond defaults
= 1 - P(NN) - P(DD)

rho = default correlation

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11
Q

Probability of default with > 2-bond CDO structure

Coval

A

uses a binomial distribution

p(k) = (n choose k) * prob default ^ k * (1 - prob. default)^(n - k)

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12
Q

Senior and junior tranche payouts of CDOs

Coval

A

senior tranche payout = min(size of senior tranche, total payout)

junior tranche payout = min(size of junior tranche, total payout - senior payout)

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13
Q

Expected payout for each tranche

Coval

A

expected payout = probability weighted average of the tranche payouts

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14
Q

Relationships b/w expected payout of each tranche (2)

Coval

A
  1. generally E[payout(Jr)] < E[payout(Sr)] due to increased riskiness
  2. with perfect correlation (rho = 1), E[payout(Jr)] = E[payout(Sr)]
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15
Q

Relationships b/w correlation and default probabilities (3)

Coval

A
  1. when bonds are uncorrelated (rho = 0), default prob. of senior tranche is much < default prob. of junior tranche
  2. when bonds are perfectly correlated (rho = 1), prob. default for either tranche = prob. default for the individual bonds (senior tranche does not benefit from CDO)
  3. As correlation decreases, pr(default - senior) decreases and pr(default - junior) increases
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16
Q

Relationship between default probability and expected bond payout and tranche sensitivity

(Coval)

A

as default probability increases, expected payoff decreases (junior tranche is the most sensitive)

17
Q

Relationship between default correlation and riskiness of senior tranche

(Coval)

A

as default correlation increases, more risk is shifted to the senior tranche

18
Q

Price of a tranche in a CDO

Coval

A

price = PV(expected tranche payout)

19
Q

Relationship between price, yield, and correlation of junior and senior tranches in a CDO

(Coval)

A

generally price(Jr tranche) < price(Sr tranche) and the junior tranche will have higher yield due to increased riskiness

w/perfect correlation, price(Jr tranche) = price(Sr tranche)

20
Q

Ways to ensure as many tranches as possible have credit ratings > average credit rating of the underlying assets (2)

(Coval)

A
  1. increase the # of assets in the pool

2. apply the CDO structure more than once

21
Q

CDO^2

Coval

A

CDO structure consisting of 2 or more junior tranches (ex: junior tranche from the original CDO + a junior tranche of a separate CDO)

22
Q

Credit ratings are typically based on (2)

Coval

A
  1. likelihood of default

or

  1. severity of a loss, given default

> > measure of expected payoff

23
Q

Issues with determining credit ratings of structured finance securities/CDOs (2)

(Coval)

A
  1. underlying pool may have many correlated assets

2. CDOs magnify the impacts of imprecise default estimates (and CDO^2s even more so)

24
Q

Sub-prime mortgages and relationship to structured finance securities

(Coval)

A

mortgages that did not meet size & credit quality requirements to be packaged into mortgage-backed securities and resold on the capital markets with a government guarantee

sub-prime mortgages were repackaged into non-backed collateralized mortgage obligations (CMOs) that were similar to CDO^2s

25
Q

Impacts of increased default rates on mortgage-backed securities during the sub-prime crisis (4)

(Coval)

A

there was:

  1. higher than expected default correlation from overlapping geography & vintages of mortgages
  2. higher than expected probability of default b/c of deteriorating credit quality of sub-prime borrowers
  3. lower than expected asset recovery values b/c of low housing prices
  4. prevalence of CMOs (= CDO^2s) magnified the impacts of the preceding assumptions differing from expectations
26
Q

Systematic risk in the context of CDOs (and high and no systematic risk)

(Coval)

A

whether a security is more likely to default when there is a recession or stock market decline

high systematic risk when default likelihood is high when the economy is poor
no systematic risk when default likelihood is independent of economic state

27
Q

Credit ratings and systematic risk

Coval

A

credit ratings do not consider systematic risk

28
Q

Implication of credit ratings ignorance of systematic risk

Coval

A

possible for 2 securities with the same credit rating to have drastically different exposure to systematic risk

29
Q

Yield spread with and without systematic risk

Coval

A

without systematic risk: yield spread is consistent with expected losses

with high systematic risk, a significant yield spread is required to compensate for additional systematic risk

30
Q

Systematic risk of senior tranches in CDOs

Coval

A

high systematic risk exposure in senior tranches because losses are magnified as the economic conditions worsen

31
Q

Reasons the yields on structured finance products (/CDOs) did not reflect the underlying risks (2)

(Coval)

A
  1. credit ratings understated default risks b/c they were based on favorable extrapolations of economic conditions
  2. yields did not account for exposure to systematic risk
32
Q

Other issues related to the rise & fall of the structured finance market (4)

(Coval)

A
  1. rating agencies misestimated default probabilities and correlations
  2. banks were happy to collect fees for structuring and origination
  3. bond issuers pay for credit ratings > conflict of interest
  4. analysts & managers knew how actions would affect profits which conflicted with accurate risk assessments
33
Q

Coval’s solution to parameter uncertainty in the structured finance market and its implication

(Coval)

A

use a Bayesian approach to acknowledge parameter uncertainty in the credit rating process

implication: fewer AAA-rated tranches

34
Q

Recovery rate

Coval

A

amount of potential payment paid in the event of default

35
Q

How to measure sensitivity of tranches to changes in default rates

(Coval)

A

calculate probability of jr & sr default before and after change

largest change is most sensitive (senior)

CAS Exam 9 (26 decks)

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