Credit Risk Management Credit Derivatives and Structured Products 2 — Questions and Answers
Question 1: What is 'attachment point' in a CDO or tranche structure?
- The date when interest payments begin on a tranche
- The portfolio loss level at which a tranche starts experiencing losses (Correct answer)
- The minimum credit rating required for inclusion in a CLO
- The initial margin posted by the protection buyer
Correct answer: The portfolio loss level at which a tranche starts experiencing losses
The attachment point defines the cumulative portfolio loss percentage at which a given tranche begins absorbing losses; below the attachment point, more junior tranches bear the loss.
Question 2: What is 'counterparty credit risk' in derivatives?
- The risk that the underlying reference entity defaults on its bonds
- The risk that the counterparty to a derivative contract fails to fulfill its obligations (Correct answer)
- The risk that collateral pledged by the counterparty declines in value
- The risk that market rates move against the position
Correct answer: The risk that the counterparty to a derivative contract fails to fulfill its obligations
Counterparty credit risk is the risk that a derivatives counterparty defaults before the final settlement of the contract, resulting in a mark-to-market loss.
Question 3: What does CVA stand for in derivatives pricing?
- Collateral Value Adjustment
- Credit Valuation Adjustment (Correct answer)
- Central Variation Amount
- Counterparty Verification Algorithm
Correct answer: Credit Valuation Adjustment
CVA is the market value of counterparty credit risk in a derivatives portfolio; it represents the expected loss from counterparty default, net of recovery.
Question 4: What is a 'basket CDS'?
- A CDS on a single investment-grade borrower
- A CDS that references multiple names, with triggers depending on the number of defaults in the basket (Correct answer)
- A CDS priced using a basket of commodity indices
- A CDS traded on an exchange rather than OTC
Correct answer: A CDS that references multiple names, with triggers depending on the number of defaults in the basket
A basket CDS references a portfolio of names; variants include first-to-default (FTD) swaps, which are triggered by the first default in the basket.
Question 5: What does 'mark-to-market' mean in the context of a CDS position?
- Recording the CDS at the notional principal amount
- Valuing the CDS at current fair value based on prevailing market spreads (Correct answer)
- Settling all payments at the original contracted spread
- Accounting for CDS only at maturity or credit event
Correct answer: Valuing the CDS at current fair value based on prevailing market spreads
Mark-to-market (MtM) values a CDS position daily based on current market CDS spreads, reflecting changes in the reference entity's credit quality.
Question 6: What distinguishes a 'funded' credit derivative from an 'unfunded' one?
- Funded derivatives are exchange-traded; unfunded are OTC
- In funded structures, the investor provides upfront cash; in unfunded (like CDS), no upfront principal is exchanged (Correct answer)
- Funded derivatives have no credit event triggers; unfunded have multiple
- Funded structures offer no return to investors; unfunded structures do
Correct answer: In funded structures, the investor provides upfront cash; in unfunded (like CDS), no upfront principal is exchanged
Funded credit derivatives (e.g., CLNs, CDOs) require the investor to post cash upfront, whereas unfunded derivatives (e.g., CDS) involve no principal transfer at inception.
Credit Risk Management Credit Derivatives and Structured Products 2
What is 'attachment point' in a CDO or tranche structure?