Topic 33: Credit Derivatives and Credit-Linked Notes Test ID: 8829604

Question #1 of 18 Question ID: 440160

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

A) obtain a higher correlation.

B) obtain a higher coupon.
C) lower the principal risk of the portfolio.
D) lower the credit risk of a position.

Explanation

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.

Question #2 of 18 Question ID: 440165

Which of the following statements is correct?

A) Liquidity issues may arise from cash settlement.

B) Senior baskets credit protection is capped.
C) Credit linked notes (CLN) remove counterparty risk for the CLN issuer.

D) Credit default swaps (CDS) are single period securities.

Explanation

In the CLN structure, the protection seller has already advanced the funds (principal) when purchasing the note. Hence, the CLN
issuer has no counterparty risk. Subordinated baskets have caps on their payoffs. CDS are typically multi-period securities.
Liquidity may become an issue under physical settlement where the protection buyer needs to buy the reference asset in the
open market for delivery.

Question #3 of 18 Question ID: 440163

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) on organized exchanges and are liquid.
C) among private parties and are illiquid.
D) among private parties and are liquid.

Explanation

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

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Question #4 of 18 Question ID: 440167

Under a credit-linked note (CLN), the credit and default risk in the event of a credit downgrade without default of the reference
bond is borne by:

A) both CLN buyer and seller through the embedded credit default swap.
B) the CLN seller.
C) the CLN buyer.
D) neither CLN buyer or seller because of the embedded credit default swap.

Explanation

In the event of a downgrade of the reference bond with no default, the CLN seller effectively transferred the credit and default risk
of the bond to the CLN buyer.

Question #5 of 18 Question ID: 440153

In the event of default, the buyer of a credit default swap that specifies a physical delivery will deliver the reference obligation to
the seller of the swap and receive:

A) a single payment equal to the par value of the obligation.

B) a single payment equal to the market value of the obligation.
C) a similar non-defaulting obligation.

D) all payments on a pre-default schedule.

Explanation

In the event of default, the buyer of a credit default swap that specifies physical delivery will deliver the referenced obligation to
the seller of the swap and receive the par value of the obligation.

Question #6 of 18 Question ID: 440155

The notional principal of a default swap is $30,000,000, and the reference price is 100%. The final price is estimated at 25%,
and the annual coupon rate was 9%. It has been 60 days since the last coupon payment. What is the cash amount to settle the
swap?

A) $7,950,000.
B) $22,050,000.
C) $22,500,000.
D) $19,800,00.

Explanation

The cash settlement of the default swap is the notional principle times the reference amount minus the final price and accrued
interest:

settlement amount = $30,000,000 [100% (25% + 9% (60 / 360))] = $22,050,000.

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Question #7 of 18 Question ID: 440154

Credit events typically include all of the following EXCEPT:

A) bankruptcy.
B) failure to make required payments.
C) invocation of cross-default clause.
D) liability claim.

Explanation

Liability claims would be covered under insurance contracts, not credit default swaps. Bankruptcy, failure to pay, restructuring,
repudiation, moratorium, obligation acceleration, and obligation default are considered credit events.

Question #8 of 18 Question ID: 440161

Which of the following statements is CORRECT? Receiving in a total rate of return (TROR) is the same as:

A) buying a default swap and owning a risk-free bond.

B) buying a default swap and shorting a risk-free bond.
C) selling a default swap and shorting a risk-free bond.
D) selling a default swap and owning a risk-free bond.

Explanation

The receiver in a TROR is receiving a capital gain/loss (as well as coupons) that are affected by both the credit risk of the issue
and market-wide interest rate risk. Selling a credit default swap entails accepting the credit risk of a bond. Buying a risk-free bond
entails interest rate risk. Therefore, receiving in a TROR is the same as selling a default swap and owning a risk-free bond.

Question #9 of 18 Question ID: 440159

MGN Bank recently bought credit default protection of $15 million notional value against each of three sovereign bonds it holds in
its portfolio of securities. The credit default protection is in the form of credit default swaps (CDS) with three years to maturity. If
all three sovereign governments default on their bonds within the next year, compute the payoffs assuming the CDS had first-
to-default and third-to-default structures, respectively, assuming the recovery rate on each bond is 50%.

First-to-default Third-to-default

A) $30 million $7.5 million

B) $7.5 million $15 million

C) $30 million $15 million

D) $7.5 million $7.5 million

Explanation

Under the first-to-default structure, MGN Bank would receive payment on the first default. The payoff would be (notional value)
(1 recovery rate), or ($15 million) (1 0.50) = $7.5 million. No further payments would be made.

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Under the third-to-default structure, no payment would be made for the first two defaults. The payoff would then be made only for
the third default for $7.5 million, with no further payments.

Question #10 of 18 Question ID: 440158

The payoff to an investor in a tranched basket default swap (TBDS) is higher when the number of assets is:

A) higher, and the assets' default correlations are low.

B) lower, and the assets' default correlations are low.
C) higher, and the assets' default correlations are high.
D) lower, and the assets' default correlations are high.

Explanation

The higher the number of assets and the lower the default correlation, the higher the investor's payoff in a TBDS. With basket
default swaps, the exposure is typically to a small number of defaults (in a large basket). So, the probability of a small number of
defaults is greater when correlation is low (due to defaults being independent of one another). With an nth-to-default CDS, the
payoff occurs when the nth default occurs in the basket.

Question #11 of 18 Question ID: 384124

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

A) The investor receives a higher coupon.

B) The investor assumes higher credit risk.
C) The investor assumes lower credit risk.

D) The investor is guaranteed the principal.

Explanation

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

Question #12 of 18 Question ID: 444812

Credit default swaps (CDS) indices least likely:

A) are equally weighted.

B) have finite lives.
C) are not tradable.
D) serve as credit benchmarks for a region.

Explanation

CDS indices are usually tradable.

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Question #13 of 18 Question ID: 440156

The type of basket default swap that usually makes a payment on the default of a single reference entity and then terminates is
the:

A) senior basket default swap.

B) Nth-to-default swap.
C) subordinate basket default swap.
D) inverted swap.

Explanation

The Nth-to-default swap makes no payments on the 1, 2, ...N-1 defaults nor on the N+1, N+2 defaults. Payments are only made
on the Nth default, and then the swap terminates.

Question #14 of 18 Question ID: 440164

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

A) there is a large credit downgrade.

B) there is a default.
C) there is no credit downgrade.
D) there is a small credit downgrade.

Explanation

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.

Question #15 of 18 Question ID: 440166

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

A) Credit risk of the bond.

B) Yield curve risk.

C) Counterparty risk of the CLN issuer.

D) Correlation risk.

Explanation

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.

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Question #16 of 18 Question ID: 440168

Which of the following statements about a total return swap (TRS) are CORRECT?
I. The party paying LIBOR plus a spread is the TRS receiver.
II. A TRS is similar to a CDS in that the protection seller is liable for credit risk only.
III. Payments are traditionally netted and a notional principal is not exchanged.
IV. The TRS receiver is responsible for payments to the counterparty on negative returns of the reference asset.

A) II and III.
B) I, III and IV.
C) II and IV.
D) I and III.

Explanation

Statement I is correct. The TRS payer pays the total return on a reference asset, while the TRS receiver typically pays a floating
rate such as LIBOR plus a spread. Statement II is incorrect. Under a TRS a protection seller bears all risk (market risk, interest
rate risk, etc.), not just credit risk. Statment III is correctthis is similar to other OTC derivatives. Statement IV is correct. The
TRS receiver must compensate the TRS payer for negative returns on the reference asset.

Question #17 of 18 Question ID: 440162

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

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

B) 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.
C) has no coupon, and redemption value is based on the repayment of the underlying loans.
D) is a pool of unguaranteed auto loans.

Explanation

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.

Question #18 of 18 Question ID: 440157

For a Nth-to-default swap, the credit protection it offers would most likely equal a:

A) subordinate basket default swap if N = 0.

B) subordinate basket default swap if N = 1.
C) senior basket default swap if N = 0.
D) senior basket default swap if N = 1.

Explanation

Of all the possible answers, this is the best one because a subordinate basket default swap makes a payment on the first default
as will a Nth-to-default swap if N=1. A senior basket default swap does not make a payment until some threshold is reached,
which is usually set so more than one reference entity must default before there is a payout. There is no such thing as a Nth-to-

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default swap where N=0.

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