Structured Products

Question 1

What is meant by structuring?

Answer 1

Engineering new financial products from existing assets.

it invloves creating instruments that exhibit particular attributes (e.g. risk, taxation, liquidity)

Question 2

What are the major types of structuring?

Answer 2

• Credit derivatives;
• CDOs;
• Equity linked structured products, their primary purpose is to generate fees for the issuer . They are not typically collateralized with risky assets

Question 3

What is meant by a complete market?

What is meant by a state of the world?

Answer 3

• A market in whicht there are securities that meet the needs of all participants
• A theoretical concept that describes an outcome of the economy with specific values of economically significant variables

Structured products are market completers.

State of the world enable us to understand incomplete markets

Question 4

What is a CMO?

Answer 4

A structured product in which the cash lows of a pool of mortgages or mortgage related products are distributed into tranches that differ in terms of maurity and seniority in receiving cash flows generated by the pool , and thus in terms of risk and return

Question 5

In addition to Sequential pay CMO, what are the other types of CMOs

Answer 5

1. PAC tranche
2. TAC tranche
3. PO only tranche and IO only tranche
4. Floaring rate tranche

Question 6

What are the motivations for investors for structured mortgage products?

Answer 6

1. Risk management
2. Return enhancement

Question 7

What is the primary risk for CMBS and subprime RMBS?

Answer 7

Default risk

Question 8

What is the structural credit risk model approach to modeling credit risk

Answer 8

The model relates valuation of debt seurities to the debt issuing firm’s financial characteristics(e.g. debt equity ratios and volatility of asset values) and uses option pricing theory to account for credit risk and factors that drive the default process.

Question 9

What is the basic assumption of strutural credit risk model?

Answer 9

A levered operating firm has a simple capital structure consisting of 2 securities:

1. A zero coupon Boind and
2. One class of non-dividend paying equity.

Question 10

Under the structural approach to credit risk modeling:

1. What is the call option view of capital structure?
2. What is the put option view of capital structure?

Answer 10

1. E = c (long call option with an exercise price equal to the face value of the firm’s debt and an expiration date equal to the maturity of he debt)
2. D= X-p (risk less bond and a short put option onthe firm’s assets)

Assets = E + D = c + (X-p)

Question 11

What is a CDO?

What are the 3 tranches of security for a CDO?

Answer 11

They apply cash flow structuring to cash flows from portfolios of debt securities and structue them into several tranches.

1. The senior tranche, they have the highest priority to the CDO’s cash flows
2. Mezzanine tranche
3. Equity tranche, they have the lowest priority to CDOS cash flows

Question 12

1. What is the lower attachment point of a CDO?
2. What is the upper attachment point of a CDO?

Answer 12

1. The first % loss in the collateral pool that causes reduction in a tranche
2. The highest % loss point at which a tranch is wiped out

Question 13

What are the 2 types of credit risk models and describe each?

Answer 13

1. Structural credit risk models: The expicitly model a firm’s default using factors such as asset volatility, leverage levels, and structuring of cash flows (i.e. its capital structure)
2. Reduced from credit models: These models focus on default probabilities based on observed market data of securities with similar risks.

The key to reduced form credit models is that credit risk is understood by analyzing similar credit risks

Question 14

Under the reduced form credit model, what is the formula for expected credit loss?

Answer 14

ECL = PD x EAD x (1-RR)

Probability of default,

Exposure at default

Recovery rate

Question 15

1. What is risk neutral approach to pricing a credit risk bond?
2. What are risk neutral investors?

Answer 15

1. Investors are risk neutral
2. Investors are indifferent to the amount of risk they bear and, thus, require the same return regardless of risk

Question 16

What is the risk neutral probability of default, lamda?

Answer 16

(1/1-RR) x (s/(1+r+s)

If r and s are small, lamda = s/(1-RR)

Question 17

What are derivatives and what are credit derivatives?

Answer 17

Derivatives are instruments whose values are diven by an underlying asset and that provide a cost effective way to transfer risk.

Credit dervatives are OTC instruments that transfer risk from a buyer of credit protection to a seller of credit protection

Question 18

What are the 3 economic roles of credit derivatives?

Answer 18

1. Risk management and diversification
2. Liquidity
3. Price revelation (or price discovery)

Question 19

What are the 3 major groupings of credit derivatives?

Answer 19

1. Single name vs multi name credit derivatives:, most commonly used single name credit derivative is the CDS
2. Unfunded vs funded credit derivatives: CDS is an example of an unfunded credit derivative, CLN is an eample of a funded credit derivative
3. Soverign vs non-soverign credit derivative:

Question 20

What are the 2 primary types of CDS, explain each

Answer 20

1. CDS, an OTC bilateral contract in which a credit protection buyer pays a periodic premium on a predetermined amount to a credit protection
2. TRCS (Total Return credit swap), an agreement between 2 parties in which the credit protection buyer makes payments to the credit protection seller based on credit risky reference asset’s total return (i.e. coupon plus capital gains/ losses)). In return, the credit protection seller makes fixed periodic payments to the protection buyer

Question 21

What are the key terms of a CDS agreement, per standard ISDA agreement?

Answer 21

1. CDS spread (CDS premium)
2. Contract size and maturing
3. Trigger events
4. Settlement, this can be cash settlement or physical settlement. In physical settlement, the protection seller purchases the distressed/ impaired bond at face value from the credit protection buyer, and places it in the balance sheet. Physical settlements occur more frequently than cash settlement
5. Delivery

Question 22

What are the 4 parameters that uniquely define a CDS?

Answer 22

1. Credit reference (referenced asset)
2. Notional amount
3. CDS spread
4. CDS maturity

Question 23

What is mark to market adjustment of a CDS

Answer 23

• If the market premium becomes wider than the contract premium, it is a gain to the buyer
• If it becomes tighter, it is a gain to the seller

Question 24

What are the 3 ways of unwinding a CD?

Answer 24

1. Entering an offsetting position
2. Assigning the conract
3. Terminating the contract

Question 25

What are credit options?

Answer 25

They are credit derivatives that resemble classic options and, like CDs, may be used to transfer or accumulate credit exposure.

Question 26

What are credit linked notes, CLN?

Answer 26

CLNs are coupon paying bonds issued by one entity with reference to another entity’s credit risk or a basket of credit risks.

Question 27

What are the 2 leading global CDS indices?

Answer 27

1. CDX, Exposure to investment gade firms in North America
2. iTaxx covers Europe, Asia and Ausralia