Credit Risk Management Credit Derivatives and Structured Products

Question 1

What is a Credit Default Swap (CDS)?

Accepted Answer

A bilateral contract where the protection buyer pays a premium to hedge against a credit event on a reference entity

Answer

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?

Accepted Answer

The annual premium (in basis points) paid by the protection buyer as a percentage of notional

Answer

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?

Accepted Answer

Credit default swaps referencing a portfolio of names

Answer

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?

Accepted Answer

Equity (first loss) tranche

Answer

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?

Accepted 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

Answer

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.

Credit Risk Management Practice Test

Credit Risk Management Practice Test

Credit Risk Management Credit Derivatives and Structured Products