FRM4 - Credit Risk Transfer Mechanisms

Question 1

Compare different types of credit derivatives, explain their applications, and describe their advantages

Answer 1

• collateralised debt obligation is a product backed by a pool of debt instruments
• credit default swap is in essense insurance against default of a counterparty
• mortgage backed security is a product backed by residential mortgage loans

Question 2

Explain different traditional approaches or mechanisms that firms can use to help mitigate credit risk

Answer 2

• purchase insurance from a third party guarantor
• netting of exposures to counterparties
• requiring collateral to be posted

Question 3

Evaluate the role of credit derivatives in the 2007-2009 financial crisis and explain changes in the credit derivative market that occurred as a result of the crisis

Answer 3

Credit derivatives themselves not the problem, those who abused them led to the issues

Many credit derivative products ceased after the crisis, some have come back in slightly different forms

Question 4

Explain the process of securitisation, describe a special purpose vehicle (SPV), and assess the risk of different business models that banks can use for securitised products

Answer 4

Securitisation is repackaging loans and other assets into new securities that can be sold on securities markets, with the collateral being the pool of loans and other assets.

The performance of the new securities depends on the performance of the collateral.

SPVs purchases the pool of loans from the originating entity and takes ownership. Obtains funds by selling the new securities.

Different business models include originate to hold and originate to distribute, OTH faces credit, pricing and liquidity risk. OTD addresses these issues.