aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.

aianjie

 

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.