AIM 1: Describe a credit-linked note, including its risks and benefits.

1、Regarding the market for credit-linked notes (CLNs), which of the following is TRUE? The notes are often traded:

A) on organized exchanges but are illiquid.

B) among private parties and are liquid.

C) among private parties and are illiquid. 

D) on organized exchanges and are liquid.

The correct answer is C

Credit-linked notes (CLNs) are often traded among private parties and are illiquid. Investors may find it difficult to redeem them prior to maturity.

2、The maximum benefits to the buyer of a credit-linked note (CLN) accrue when:

A) there is a small credit downgrade.

B) there is no credit downgrade.

C) there is a large credit downgrade.

D) there is a default.

The correct answer is B

The benefit to the CLN buyer is that the buyer earns a high return if there is no downgrade or default. The buyer’s primary risk is that there is a downgrade or default and the buyer earns a lower return.

3、Which of the following is least likely a relevant risk for the buyer of a credit-linked note (CLN)?

A) Yield curve risk.

B) Credit risk of the bond.

C) Counterparty risk of the CLN issuer.

D) Correlation risk.

The correct answer is A

The CLN buyer has the credit risk of the issue because if there is a downgrade, he would earn a lower return. He also has counterparty risk because the CLN issuer could possibly default on her obligation. There is also correlation risk if the default risks of the CLN issuer and bond issuer are highly correlated. Furthermore, CLNs are often privately traded and illiquid, so CLN investors may have a difficult time redeeming them prior to maturity. The CLN buyer has relatively little exposure to yield curve risk.

4、An asset-backed, credit-linked note (CLN):

A) is a pool of unguaranteed auto loans.

B) combines asset-backed securities with the performance of an equity index.

C) is a debt obligation with a coupon that varies with credit risk and a redemption value linked to the performance of a portfolio of loans.

D) has no coupon, and redemption value is based on the repayment of the underlying loans.

The correct answer is C

A CLN is a debt obligation bearing a coupon rate based on credit risk. The redemption value of the obligation is linked to the performance of a portfolio of loans. In exchange for the coupon, the holder participates in the credit risk of the loan portfolio.

5、A fixed-income investor would purchase credit-linked notes in order to:

A) lower the credit risk of a position.

B) obtain a higher correlation.

C) obtain a higher coupon.

D) lower the principal risk of the portfolio.

The correct answer is C

Credit-linked notes have an imbedded credit option. Investors of credit-linked notes assume a greater amount of credit risk in exchange for a higher coupon.

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.

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.

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.

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.

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.

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).

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.

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.

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.

The correct answer is D

The assets can either be managed or held static.

4、A collateralized debt obligation (CDO) pays out in tranches where each tranche has a specific level of credit protection. Which of the following lists tranches from highest priority of payment to lowest priority of payment?

A) Mezzanine tranche, equity tranche, senior tranche.

B) Collateralized tranche, equity tranche, mezzanine tranche.

C) Equity tranche, collateralized tranche, mezzanine tranche.

D) Senior tranche, mezzanine tranche, equity tranche.

The correct answer is D

As its name implies, the senior tranche has the highest priority of payment. Mezzanine is next, and equity gets paid only after the other tranches have been paid.

5、In the creation of collateralized obligations, a bank is likely to use a special purpose vehicle (SPV) by:

A) purchasing from the SPV the underlying asset pool backing a collateralized obligation.

B) having the SPV conduct an auction of mortgages and invest the proceeds in equity. 

C) transferring the underlying asset pool of the collateralized obligation to the SPV.

D) having the SPV conduct an auction of credit-quality mortgages and invest the proceeds in subprime loans.

The correct answer is C

In the creation of collateralized obligations, a bank is likely to use a SPV by transferring the underlying asset pool of the collateralized obligation to the SPV. Once the assets that comprise the underlying pool are transferred to the SPV, they are legally owned by the SPV. Thus, if the bank experiences financial distress, the SPV is not directly affected. This legal relationship is known as bankruptcy remote.

AIM 3: Describe the difference between a cash and synthetic CDO.

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

A) Balance sheet-driven are the majority of cash CDOs.

B) An arbitrage CDO is issued to profit on the spread between the return on the underlying assets and the return paid to investors.

C) Cash CDOs have three phases in their lifetime. 

D) During the reinvestment phase, cash flows from prepayments and default recoveries are reinvested.

The correct answer is A

Arbitrage CDOs are the majority of cash CDOs and are issued to profit on the spread between the return on the underlying assets and the return paid to investors. A bank or insurance company wishing to reduce their loan exposure on the balance sheet creates a balance sheet CDO. Cash CDOs have three phases in their lifetime. During the ramp up phase, the portfolio is created using financing from different tranches. During the reinvestment phase, cash flows from prepayments and default recoveries are reinvested, assuming coverage tests are satisfied. In the pay down phase, principal payments are made to junior and senior tranche holders and the CDO is wound down.

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

A) The ramp up period is longer than that for cash CDOs.

B) The senior portion doesn’t require funding.

C) A credit default swap is sold. 

D) The junior section absorbs losses before the senior section.

The correct answer is A

In a synthetic CDO, the ramp up period is shorter than the ramp up period for cash CDOs because no actual (cash) debt obligations are purchased. Instead, the synthetic CDO gains exposure and earns a return by selling a credit default swap. By selling a credit default swap, they pay the buyer a specific amount if a credit event occurs (e.g. bankruptcy) and in return receive a swap premium. In essence, the CDO has credit exposure and earns a return just as if they had bought the underlying bond. The senior portion doesn’t require funding and the junior section absorbs losses before the senior section.

3、Which of the following best describes the difference between cash and synthetic collateralized debt obligations (CDOs)? In a synthetic CDO, the assets are:

A) on the balance sheet, and a default swap is purchased.

B) off-balance sheet, and a risk-free bond is purchased.

C) on the balance sheet, and a risk-free bond is purchased. 

D) off-balance sheet, and a default swap is purchased.

The correct answer is B

In a synthetic CDO, the special-purpose vehicle (SPV) does not invest in the underlying assets but instead gains exposure to the assets by selling a default swap. The SPV uses the swap premium and cash from selling tranches to invest in a risk-free bond. In a cash CDO, the SPV does purchase the underlying assets.

4、Synthetic collateralized debt obligations:

A) directly invest in loans but not bonds.

B) directly invest in both loans and bonds.

C) directly invest in bonds but not loans.

D) do not directly invest in underlying loans and bonds.

The correct answer is D

Synthetic collateralized debt obligations typically do not directly invest in either bonds or loans. Instead, they gain exposure to the risk and return of these instruments via derivatives.

5、With respect to the use of credit default swaps and total return swaps, a synthetic collateralized debt obligation can use:

A) neither to obtain exposure to the return of loans and bonds. 

B) both to obtain exposure to the returns of loans and bonds.

C) only credit default swaps to obtain exposure to the returns of loans and bonds.

D) only total return swaps to obtain exposure to the returns of loans and bonds. 

The correct answer is B

Synthetic CDOs use both credit default swaps and total return swaps to obtain the desired exposure to loans and bonds.

6、Synthetic collateralized debt obligations typically receive income from:

A) selling credit protection but not from investing in assets using capital from investors.

B) investing in assets using capital from investors but not from selling credit protection.

C) selling credit protection and from investing in assets using capital from investors.

D) neither selling credit protection nor from investing in assets using capital from investors.

The correct answer is C

The CDO “sells” protection by taking on credit risk with derivatives. The CDO invests the capital of investors in traditional assets, e.g., bonds, which earn a return.