Coval, Jurek, & Stafford: Economics of Structured Finance

Question 1

Structured finance

Answer 1

involves pooling financial assets and creating capital structure of claims (tranches) against these pools

prioritization scheme exists where many of tranches are safer than average asset that makes up the pool

Question 2

structured securities became very popular because

Answer 2

of ability to create “safe” assets from risky collateral

Question 3

rating agencies were rating these assets as

Answer 3

being virtually risk free

market participants believed that they were great investments due to lack of historical defaults due to a period of strong economic growth as well as fact that they were rated

Question 4

Asset backed security, ABS

Answer 4

structured security investment

an entity can create asset backed security in order to remove certain financial assets from its balance sheet

credit risk of the assets will be transferred to purchasers of securities

Question 5

to create ABS

Answer 5

firm transfers assets to a special purpose vehicle, SPV, which then issues securities backed by cash flows of the assets

ABS structure often consists of several tranches each with different level of credit risk exposure

Question 6

originator of ABS can manufacture tranches to achieve

Answer 6

specific credit rating by tailoring tranches to have cash flows that would meet guidelines set by rating agencies

• senior tranche is usually rated AAA as it experiences credit losses last
• can achieve this rating even if entire asset pool consists of lower rated assets

Question 7

this AAA rating may not be appropriate if

Answer 7

underlying assets are highly correlated

Question 8

due to high level of risk mezzanine/middle tranches

Answer 8

are often difficult to sell

-in order to, some dealers have repackaged mezzanine tranches from several different asset backed securities into a new ABS known as ABS CDO aka CDO^2

Question 9

senior tranche of ABS CDO usually receives

Answer 9

a AAA rating

• AAA rating is appropriate if losses from different tranches are independent
• if they are highly correlated, even senior tranche can be extremely risky

Question 10

CDO^2 expected payoff from a given tranche is

Answer 10

even more sensitive to default probability estimate than expected payoff of respective tranche from CDO

Question 11

as default correlation increases

Answer 11

risk shifts from junior to senior

expected payoff on junior increases relative to baseline and expected payoff of mezzanine falls

Question 12

As correlation increases

Answer 12

the differentiation between the tranches diminishes

With perfect correlation, the tranching strategy produces no differentiation in risk between the tranches

-parameters have much more significant impact on CDO^2

Question 13

as default probability increases

Answer 13

values of junior and mezzanine tranches fall quickly to 0 and value of senior tranche also falls significantly

Question 14

can conclude that even a small change in default probability or correlation can

Answer 14

have huge impact on expected payoffs and rating of CDO^2

Question 15

because structured products pool together risk from several different assets

Answer 15

non-systematic risk is usually diversified away

-as result, losses of pool are affected almost entirely by systematic risk

Question 16

investors in senior tranches bear

Answer 16

a great deal of systematic risk as they are likely to only suffer losses if overall market performs poorly

• essentially payoff from tranche is equivalent to payoff from a derivative written against a broad economic index
• due to higher levels of systematic risk, these securities need to offer higher expected returns than single name bonds that have same level of total risk

Question 17

empirical data shows that structured finance securities are not providing enough

Answer 17

of a premium: the returns may therefore be insufficient to compensate for the levels of risk