FRM 4 CREDIT RISK TRANSFER MECHANISM Flashcards
What is the main purpose of credit derivatives?
To minimize exposure to credit risk by transferring credit risk from one party to another without transferring the underlying portfolio.
What are the advantages of credit derivatives?
- Allow transfer of credit risk
- Improve market information
- Enhance liquidity
- Absorb shocks in financial markets
What is a credit default swap (CDS)?
A financial contract where one party pays a fixed annual fee to another party, who compensates for losses if a credit event occurs.
List some disadvantages of credit default swaps (CDSs).
- Create a false sense of security
- Speculative trading can increase premiums
- Difficult to define and price default events
- Can lead to moral hazard problems
- Weak regulation before 2007
What is a first-to-default put?
A type of credit derivative that compensates the buyer for the first default among a portfolio of loans.
How do collateralized debt obligations (CDOs) function?
CDOs are structured products that pool various debt assets, slice them into tranches based on risk, and sell them to investors.
What are the advantages of collateralized debt obligations (CDOs)?
- Free up capital for banks
- Cater to different investor risk tolerances
- Higher profit potential from loan turnover
- Convert illiquid securities into liquid ones
- Direct transfer of risk
What is the definition of a collateralized loan obligation (CLO)?
A structured financial product similar to a CDO, but primarily backed by bank loans instead of mortgages.
What is a total return swap (TRS)?
A financial contract that mirrors the total return of an underlying asset, transferring both market and credit risk from the seller to the buyer.
What happens in a total return swap (TRS) transaction?
The purchaser receives cash flows from the underlying asset and pays floating payments, while the seller pays the total return.
What are credit spread options?
Options trading strategies that involve buying one option and selling another to manage credit risk.
What traditional approaches can firms use to mitigate credit risk?
- Purchasing insurance from third-party guarantors
- Netting of exposures
- Marking-to-market/margining
- Requiring collateral
- Termination/put options
- Syndication and secondary market transactions
What is the role of a special purpose vehicle (SPV) in securitization?
An SPV is used to isolate financial risk and hold the underlying assets to facilitate the securitization process.
What are the key elements of a credit event in credit derivatives?
- Failure to make a required payment
- Restructuring that worsens creditor position
- Invocation of a cross-default clause
- Bankruptcy
True or False: Credit derivatives can only transfer credit risk without any associated fees.
False
Fill in the blank: A _______ is a financial contract that allows the transfer of credit risk of an underlying portfolio.
credit derivative
What are the two types of syndicate arrangements in loan transactions?
- Firm commitment
- Best efforts
What is a key disadvantage of collateralized debt obligations (CDOs)?
They can be highly complex to understand.
How do CDOs help banks manage capital?
By selling CDOs, banks can free up capital for other lending activities.
What is the main difference between CDOs and CLOs?
CDOs include a variety of debt assets, while CLOs primarily include bank loans.
What should the default and floating payment correspond to?
The bank’s funding cost
If a buyer leverages its position by putting aside 10 percent of the initial value of the underlying instrument as collateral, what does the floating payment include?
The sum of the funding cost and a spread
What do credit spread options involve?
The purchase of one option and the sale of a second similar option with a different strike price
What is the initial premium paid by the buyer of a credit spread option in exchange for?
Potential cash flows if a given credit spread changes
