QFC Financial Engineering & Structured Products 3

Question 1

In the Gaussian copula model for CDO pricing, which parameter primarily captures co-movement of defaults among reference entities?

Accepted Answer

The pairwise default correlation coefficient

Answer

The risk-free term structure of interest rates

Answer

The assumed recovery rate for defaulted obligations

Answer

The hazard rate function of each individual reference name

Question 2

What is a Total Return Swap (TRS)?

Accepted Answer

A contract where one party receives all economic returns of a reference asset and pays a financing rate

Answer

A contract where one party pays fixed coupons on a bond and receives a floating benchmark rate

Answer

An exchange of fixed versus floating interest payments on a notional principal amount

Answer

A credit derivative that triggers a payment upon the bankruptcy of a reference entity

Question 3

What is the primary purpose of 'credit enhancement' mechanisms in asset-backed securities?

Accepted Answer

To improve the credit quality of senior tranches, enabling them to achieve higher ratings

Answer

To increase the yield paid to equity tranche investors as compensation for first-loss risk

Answer

To reduce the originator's regulatory capital requirements under Basel III

Answer

To ensure the SPV maintains adequate operational liquidity throughout the transaction life

Question 4

In a CDO, the 'attachment point' of a tranche refers to:

Accepted Answer

The cumulative loss level at which that tranche begins to absorb principal losses

Answer

The minimum credit rating required for assets to be included in the reference collateral pool

Answer

The date on which the tranche coupon resets from a fixed to a floating rate

Answer

The reinvestment threshold that triggers substitution of collateral during the reinvestment period

Question 5

How does default correlation affect CDO equity tranche value?

Accepted Answer

Lower correlation increases expected losses to the equity tranche; higher correlation benefits equity in a bimodal outcome

Answer

Higher correlation always increases equity tranche value by reducing expected losses

Answer

Correlation has no significant effect on equity tranches because they are first loss regardless

Answer

Higher correlation shifts losses to senior tranches, directly benefiting equity tranche holders

Question 6

How does a covered bond fundamentally differ from a traditional asset-backed security?

Accepted Answer

A covered bond remains on the issuer's balance sheet with dual investor recourse; an ABS transfers assets off-balance-sheet to an SPV

Answer

A covered bond is unrated; an ABS requires a minimum AA rating to be issued

Answer

A covered bond is backed by government securities; an ABS uses only private-sector loans

Answer

A covered bond uses synthetic CDS exposure; an ABS must hold only physical assets

Question 7

Why did senior CDO tranches suffer significant losses during the 2008 financial crisis despite holding AAA ratings?

Accepted Answer

Realized default correlation among mortgage pools spiked far above the model assumptions used at issuance

Answer

Senior tranches lacked legal priority because rating agency agreements were unenforceable

Answer

Equity tranche holders exercised put options that transferred their losses upward to senior investors

Answer

Fannie Mae and Freddie Mac, the primary CDS protection sellers, defaulted simultaneously