Week 8

Question 1

What are Asset-backed securities (ABSs)?

Answer 1

Asset-backed securities (ABSs) are created from the pooling of non-mortgage assets,

• e.g., accounts receivables, auto loans, student loans, Small Business Administration (SBA) loans, credit card receivables, and corporate bonds etc

The securities issued are called asset-backed securities since they are backed (or collateralized) by the underlying assets (accounts receivablesin this example)

Question 2

what is a CDO?

Answer 2

A CDO is a security backed by a diversified pool of one or more of the following types of debt obligations

Question 3

What are the two kinds of credit enhancement?

Answer 3

Types of Credit Enhancements

External Credit Enhancements – Provided by third parties:

• Corporate Guarantees: A parent company or external firm guarantees part of the ABS, supporting its credit quality.

Internal Credit Enhancements – Built into the ABS structure:

• Reserve Funds: Set aside to absorb losses, including:
  
  • Cash Reserve Funds: Created from issuance proceeds; invested in safe instruments.
  • Excess Spread Accounts: Funded by leftover cash flow after all obligations (e.g., coupons, fees) are paid.

Question 4

What is the hazard rate and the Expected Loss?

Answer 4

Hazard Rate:
The probability that a default occurs in a specific time period, given that it hasn’t occurred yet.

Expected Loss (EL):
The anticipated loss on a credit exposure, combining default probability and potential severity.