LOS d: Discuss credit derivatives strategies and how they are used.

Q1. Which of the following most accurately describes a basis trade using credit default swaps? The investor:

A)   buys a long-term credit default swap and sells a short-term credit default swap.

B)   exploits the difference between the credit default swap premium and asset swap spread.

C)   buys a short-term credit default swap and sells a long-term credit default swap.

Q2. Which of the following most accurately describes a credit curve steepener trade using credit default swaps? The investor:

A)   buys a short-term credit default swap and sells a long-term credit default swap.

B)   sells a credit default swap on a firm’s subordinated debt and buys a cheaper credit default swap on the senior debt.

C)   buys a long-term credit default swap and sells a short-term credit default swap.

Q3. Which of the following most accurately describes a correlation trade using credit default swaps? The investor:

A)   goes long a credit index and shorts specific credit default swaps.

B)   sells a credit default swap on a firm’s subordinated debt and buys a cheaper credit default swap on the senior debt.

C)   sells protection on a first-to-default basket of credit default swaps.

Q4. Which of the following most accurately describes the pricing of a first-to-default basket of credit default swaps in a correlation trade? The swap premium will be higher when the number of credit default swaps is:

A)   higher and when the default correlations are higher.

B)   lower and when the default correlations are higher.

C)   higher and when the default correlations are lower.

Q5. Which of the following most accurately describes the characteristics of options on credit default swaps? Options on credit indices are:

A)   less liquid than single issuer options and in a receiver option the option buyer has the right to buy a credit default swap.

B)   more liquid than single issuer options and in a receiver option the option buyer has the right to buy a credit default swap.

C)   more liquid than single issuer options and in a receiver option the option buyer has the right to sell a credit default swap.

LOS d: Discuss credit derivatives strategies and how they are used. fficeffice" />

Q1. Which of the following most accurately describes a basis trade using credit default swaps? The investor:

A)   buys a long-term credit default swap and sells a short-term credit default swap.

B)   exploits the difference between the credit default swap premium and asset swap spread.

C)   buys a short-term credit default swap and sells a long-term credit default swap.

Correct answer is B)

In a basis trade, the credit default swap premium is compared to the asset swap spread of the underlying bond. The latter refers to a bond’s yield above a benchmark in a swap. This spread should reflect the credit risk of the bond. If it is higher than the credit default swap premium, the basis is negative and the investor would buy the bond and buy the credit default swap (buy protection against the long position), thereby creating an arbitrage opportunity.

Q2. Which of the following most accurately describes a credit curve steepener trade using credit default swaps? The investor:

A)   buys a short-term credit default swap and sells a long-term credit default swap.

B)   sells a credit default swap on a firm’s subordinated debt and buys a cheaper credit default swap on the senior debt.

C)   buys a long-term credit default swap and sells a short-term credit default swap.

Correct answer is C)

In a curve trade, an investor has different opinions about the long term versus short term prospects for a bond issuer. The trade can be a flattener or a steepener. In a credit curve steepener, the investor believes that the issuer has the ability to subsist in the short term, but that its long-term prospects are poor. The sale of the short-term credit default swap partially finances the purchase of the long-term credit default swap.

Q3. Which of the following most accurately describes a correlation trade using credit default swaps? The investor:

A)   goes long a credit index and shorts specific credit default swaps.

B)   sells a credit default swap on a firm’s subordinated debt and buys a cheaper credit default swap on the senior debt.

C)   sells protection on a first-to-default basket of credit default swaps.

Correct answer is C)

In one type of correlation trade, the investor sells protection on a basket of credit default swaps. One such basket is a first-to-default swap, where the number of credit default swaps in the basket is typically five. In this structure, the investor would provide protection for the first (and only the first) default. If one of the reference obligations defaults, the investor owes the basket’s notional amount and receives the defaulted reference obligation. The name “correlation trade” comes about because the pricing of the basket default swap depends on the default correlation, which is the probability that two of the reference obligations in a basket will default concurrently. Higher default correlations result in lower premiums (the protection offered by the first-to-default basket is worth less to the protection buyer when it is likely that several of the obligations will default at the same time).

Q4. Which of the following most accurately describes the pricing of a first-to-default basket of credit default swaps in a correlation trade? The swap premium will be higher when the number of credit default swaps is:

A)   higher and when the default correlations are higher.

B)   lower and when the default correlations are higher.

C)   higher and when the default correlations are lower.

Correct answer is C)

In one type of correlation trade, the investor sells protection on a basket of credit default swaps. One such basket is a first-to-default swap, where the number of credit default swaps in the basket is typically five. In this structure, the investor would provide protection for the first (and only the first) default. If one of the reference obligations defaults, the investor owes the basket’s notional amount and receives the defaulted reference obligation. The pricing of the basket default swap depends on the default correlation, which is the probability that two of the reference obligations in a basket will default concurrently. Higher default correlations result in lower premiums (the protection offered by the first-to-default basket is worth less to the protection buyer when it is likely that several of the obligations will default at the same time). The higher the number of credit default swaps in the basket, the higher the basket’s premium (there is a greater probability of one of them defaulting).

Q5. Which of the following most accurately describes the characteristics of options on credit default swaps? Options on credit indices are:

A)   less liquid than single issuer options and in a receiver option the option buyer has the right to buy a credit default swap.

B)   more liquid than single issuer options and in a receiver option the option buyer has the right to buy a credit default swap.

C)   more liquid than single issuer options and in a receiver option the option buyer has the right to sell a credit default swap.

Correct answer is C)

Options on credit indices are more liquid than single issuer options. In a receiver option, the option buyer has the right to sell a credit default swap (go long the underlying) at some future date. In a payer option, the option buyer has the right to buy a credit default swap (short the underlying) at some future date. These options will change in value as the value of the underlying changes. They can be used to provide leverage, hedge, take a position in volatility, or to create straddles and other option strategies.

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