Credit Risk Management Credit Derivatives and Structured Products 1 — Questions and Answers
Question 1: What is a Credit Default Swap (CDS)?
- An exchange-traded equity option on a bank's stock
- A bilateral contract where the protection buyer pays a premium to hedge against a credit event on a reference entity (Correct answer)
- A bond with floating-rate coupons tied to SOFR
- A loan participation agreement between two banks
Correct answer: A bilateral contract where the protection buyer pays a premium to hedge against a credit event on a reference entity
A CDS is an OTC derivative where the protection buyer pays periodic premiums to the seller, who compensates the buyer if the reference entity experiences a defined credit event.
Question 2: What does the CDS spread represent?
- The difference between bid and ask prices for the reference bond
- The annual premium (in basis points) paid by the protection buyer as a percentage of notional (Correct answer)
- The credit rating difference between two reference entities
- The discount rate used to value the reference bond
Correct answer: The annual premium (in basis points) paid by the protection buyer as a percentage of notional
The CDS spread is the annualized cost of credit protection, expressed in basis points of notional; it reflects the market's implied probability of a credit event.
Question 3: In a synthetic CDO, credit risk is transferred through what mechanism?
- Physical sale of the underlying loans to investors
- Credit default swaps referencing a portfolio of names (Correct answer)
- Issuing covered bonds backed by mortgage collateral
- Loan participations sold to institutional investors
Correct answer: Credit default swaps referencing a portfolio of names
A synthetic CDO uses CDS contracts rather than actual loan transfers, allowing the originator to retain the assets while distributing credit risk to investors.
Question 4: Which tranche of a CDO is the first to absorb credit losses?
- Super senior tranche
- Senior tranche
- Mezzanine tranche
- Equity (first loss) tranche (Correct answer)
Correct answer: Equity (first loss) tranche
The equity or first-loss tranche absorbs the first losses in the CDO pool, protecting more senior tranches; in return, it receives the highest yield.
Question 5: What is a 'total return swap' (TRS) in credit markets?
- A swap where one party pays total economic returns (income + capital gains/losses) on a reference asset in exchange for a floating rate payment (Correct answer)
- A swap exchanging fixed-rate loan payments for floating-rate payments
- An agreement to exchange credit ratings on two reference entities
- A transaction where default risk is transferred without income transfer
Correct answer: A swap where one party pays total economic returns (income + capital gains/losses) on a reference asset in exchange for a floating rate payment
In a TRS, the total return payer passes all economic exposure (coupons plus price appreciation or depreciation) of a reference asset to the total return receiver in exchange for SOFR plus a spread.
Question 6: What is a 'credit-linked note' (CLN)?
- A note whose coupon is linked to the issuer's own credit rating
- A funded credit instrument that embeds a CDS, where the investor's principal is at risk if a credit event occurs (Correct answer)
- A government bond with a floating-rate coupon
- A convertible bond with a credit enhancement feature
Correct answer: A funded credit instrument that embeds a CDS, where the investor's principal is at risk if a credit event occurs
A CLN is a funded version of a CDS: the investor provides upfront cash, earns an enhanced coupon, but loses some or all principal if the reference entity experiences a credit event.
Credit Risk Management Credit Derivatives and Structured Products 1
What is a Credit Default Swap (CDS)?