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 Gaussian copula links individual default times using a correlation coefficient; higher correlation increases the probability of simultaneous defaults and dramatically affects tranche pricing across the capital structure.

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

In a TRS, the total return receiver gains all income and price appreciation (or depreciation) of a reference asset and pays a financing rate, achieving synthetic economic exposure without physically owning the asset.

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

Credit enhancement mechanisms — overcollateralization, subordination, reserve accounts, and guarantees — protect senior tranches from losses, enabling them to receive higher ratings than the underlying asset pool alone would support.

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 attachment point defines the loss threshold at which a tranche starts experiencing write-downs; losses below the attachment point are absorbed by more junior tranches, while losses above it erode that tranche's principal.

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

With low correlation, defaults are idiosyncratic and spread across names, generating steady losses that erode the equity tranche; with high correlation, the outcome is bimodal — either few defaults (equity intact) or widespread defaults (everyone suffers), making equity a 'correlation long' position.

(QFC) Quantitative Finance Certification Practice Test

(QFC) Quantitative Finance Certification Practice Test

QFC Financial Engineering & Structured Products 3