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.
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.
Regarding the market for credit-linked notes (CLNs), which of the following is TRUE? The notes are often traded:
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.
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:
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.
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:
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Question #7 of 18 Question ID: 440154
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.
Which of the following statements is CORRECT? Receiving in a total rate of return (TROR) is the same as:
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.
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
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.
The payoff to an investor in a tranched basket default swap (TBDS) is higher when the number of assets is:
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.
Which of the following best explains the motivation for investors to purchase a credit-linked note?
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.
Explanation
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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:
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.
The maximum benefits to the buyer of a credit-linked note (CLN) accrue when:
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.
Which of the following is least likely a relevant risk for the buyer of a credit-linked note (CLN)?
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.
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.
For a Nth-to-default swap, the credit protection it offers would most likely equal a:
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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