QFC Financial Engineering & Structured Products 1 — Questions and Answers
Question 1: In a securitization transaction, what is the primary purpose of a Special Purpose Vehicle (SPV)?
- To provide credit enhancement directly to bond investors
- To isolate the securitized assets from the originator's bankruptcy risk (Correct answer)
- To hedge interest rate risk embedded in the asset pool
- To manage prepayment speeds of the underlying loans
Correct answer: To isolate the securitized assets from the originator's bankruptcy risk
An SPV legally separates the securitized assets from the originator so that if the originator becomes insolvent, the assets remain unaffected and cash flows continue to bondholders.
Question 2: Which of the following best describes 'tranching' in a CDO structure?
- Dividing assets by maturity date to match liability duration
- Splitting a pool of cash flows into different risk/return classes with varying priority of payment (Correct answer)
- Diversifying the asset pool across multiple industry sectors
- Hedging currency risk in cross-border structured products
Correct answer: Splitting a pool of cash flows into different risk/return classes with varying priority of payment
Tranching divides cash flows from an asset pool into classes (tranches) with varying seniority, where senior tranches receive payments first and bear lower credit risk.
Question 3: What does the 'waterfall' describe in a CDO structure?
- A mechanism that accelerates amortization when asset values decline
- The sequential order in which cash flows are distributed to different tranches (Correct answer)
- A liquidity facility that ensures timely payment to all tranche holders
- The process by which collateral is substituted in an actively managed CDO
Correct answer: The sequential order in which cash flows are distributed to different tranches
The waterfall defines the priority of payment: senior tranches are paid first from available cash flows, followed by mezzanine tranches, with equity tranches receiving only the residual.
Question 4: Which asset class typically backs a Collateralized Loan Obligation (CLO)?
- Residential mortgage loans
- Credit card receivables
- Leveraged corporate loans (Correct answer)
- Investment-grade government bonds
Correct answer: Leveraged corporate loans
CLOs are structured products backed by pools of leveraged loans made to below-investment-grade corporations, which distinguishes them from CDOs that may use bonds or other credit instruments.
Question 5: In asset-backed securities, what does 'overcollateralization' as a credit enhancement technique involve?
- Pledging assets whose value exceeds the face value of the issued securities (Correct answer)
- Issuing more bonds than the underlying asset pool can support
- Using interest rate derivatives to enhance yield on lower-rated tranches
- Purchasing insurance from the originator against pool credit losses
Correct answer: Pledging assets whose value exceeds the face value of the issued securities
Overcollateralization means the asset pool's value exceeds total securities issued, providing a buffer that absorbs losses before any investor suffers a principal shortfall.
Question 6: What fundamentally distinguishes a synthetic CDO from a cash CDO?
- A synthetic CDO holds physical bonds while a cash CDO holds equities
- A synthetic CDO gains credit exposure through credit default swaps rather than physical asset ownership (Correct answer)
- A synthetic CDO is always unrated while cash CDOs require AAA senior tranches
- A synthetic CDO uses leverage while a cash CDO does not
Correct answer: A synthetic CDO gains credit exposure through credit default swaps rather than physical asset ownership
In a synthetic CDO, the SPV sells credit protection via CDS contracts to gain credit exposure without physically owning reference assets, unlike a cash CDO that holds actual bonds or loans.
Question 7: Which of the following best describes the 'equity tranche' in a structured finance transaction?
- The most senior class that bears the least credit risk in the structure
- The first-loss piece that absorbs initial credit losses from the underlying asset pool (Correct answer)
- A floating-rate note indexed to a benchmark rate plus a spread
- A guaranteed investment contract provided by a highly rated financial institution
Correct answer: The first-loss piece that absorbs initial credit losses from the underlying asset pool
The equity tranche is the most junior piece in the capital structure, absorbing the first losses from defaults in the underlying pool while receiving the residual cash flows after all senior tranches are paid.
QFC Financial Engineering & Structured Products 1
In a securitization transaction, what is the primary purpose of a Special Purpose Vehicle (SPV)?