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6、Which of the following best explains the motivation for investors to purchase a credit-linked note?

A) The investor assumes higher credit risk.

B) The investor is guaranteed the principal.

C) The investor receives a higher coupon.

D) The investor assumes lower credit risk.

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The correct answer is C

Although the investor does assume higher credit risk, the reason for purchasing a credit-linked note is generally to obtain the higher coupon payment.

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7、Suppose a risky bond has a yield of 20%. If the return on U.S. Treasuries is 5% and the default swap premium on the bonds is 19%, what will the arbitrageur’s position be?

A) Go long the Treasury, sell the default swap, and short the risky bond.

B) Go long the Treasury, buy the default swap, and short the risky bond.

C) Short the Treasury, buy the default swap, and invest in the risky bond.

D) Short the Treasury, sell the default swap, and invest in the risky bond.

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The correct answer is A

Recall the formula: risk-free bond return + default swap premium = risky bond return. An inequality tells the arbitrageur which position to take. Here it is 5% + 19% > 20%. So the arbitrageur needs to go long the left side (invest in the Treasury and earn the 19% swap premium by taking credit exposure), while shorting the right side (shorting the risky bond). The profit would be 4%. Note that interest rate and liquidity risk remain.

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AIM 2: Explain the structure of a typical cash collateralized debt obligation, including the use of a special purpose vehicle.

1、Which of the following statements regarding collateralized debt obligations (CDOs) is FALSE?

A) Interest rate swaps are rarely used due to scrutiny from rating agencies.

B) The senior tranche is usually paid a floating rate.

C) The underlying assets are junk bonds, emerging market debt, bank loans, MBS, and ABS. 

D) Mezzanine tranches receive a fixed rate.

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The correct answer is A

The collateral usually has a mix of floating and fixed rate debt so interest rate swaps are used to manage the risk from cash flow mismatches. Interest rate swaps are often used by asset managers to control the interest rate risk imposed by this mismatch, Rating agencies usually mandate the use of swaps. In CDOs there is usually a senior tranche that receives a floating rate, mezzanine tranches that receive a fixed rate, and a subordinate or equity tranche that provides prepayment and credit protection to the other tranches. The underlying assets are junk bonds, emerging market debt, bank loans, mortgage-backed securities (MBS), and asset-backed securities (ABS).

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2、Which of the following is FALSE regarding SPVs? They:

A) are legally separate from their parent.

B) use balance-sheet CDOs to avoid alienating clients.

C) use active management to earn high returns in CDOs.

D) have high credit risk due to CDO issuance.

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The correct answer is D

SPVs are legally separate from the parent and thus are not exposed to the parent’s credit risk. They are usually AAA rated. They use balance sheet CDOs when they already own the asset and wish to transfer its risk and raise capital. A CDO of this type avoids notifying the debtor that the SPV has unloaded its debt, which can sometimes harm the relationship with the debtor. The SPV usually uses active management to earn high returns for the CDO.

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3、With respect to the assets underlying a collateralized debt obligation (CDO), the assets:

A) must be actively managed and cannot be held static.

B) must be held static for at least a year before they can be actively managed.

C) cannot be held static for more than a year and must be actively managed. 

D) can either be actively managed or held static.

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The correct answer is D

The assets can either be managed or held static.