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P2.T6.210. Credit Derivatives (CLN, CDO)

David Harper CFA FRM

David Harper CFA FRM
Staff member

210.1. Acme Bank has a long position in a Mexican bond and, seeking to hedge this exposure to an emerging market, issues a credit-linked note (CLN) to Investors. In this scenario, Acme Bank is the CLN Issuer (aka, protection buyer) and Investors are CLN buyers. Each of the following is true EXCEPT for:

a. From Acme's perspective as the CLN issuer, the CLN is economically equivalent (or at least similar to) to a short bond position plus a long credit default swap (CDS) position
b. From the Investors perspective as CLN buyers, the CLN is economically equivalent (or at least similar to) to a long bond position plus a short credit default swap (CDS) position
c. The Investors (CLN buyers) have significant counterparty risk, but the CLN Issuer has virtually no counterparty risk
d. The yield paid by Acme Bank (CLN Issuer) to investors should be less than the spread on credit default swap (CDS) purchased from investors on the same reference (Mexican bond)

210.2. A collateralized debt obligation (CDO) issues three tranches to investors and consist of an underlying portfolio of (n) corporate bonds with a total principal of $100.0 million. Tranche (X) absorbs the first 10% of losses, Tranche (B) absorbs the next 30% of losses and Tranche (A) absorbs the final 60% of losses. Each of the following is true EXCEPT:

a. The junior Tranche (X) should offer the highest yield
b. The junior Tranche (X) is long the average default correlation among the underlying bonds
c. The senior Tranche (A) is short the average default correlation among the underlying bonds
d. A lower detachment point for Tranche (X) would tend to increase the credit rating Tranche (B)

210.3. Which of the following is TRUE about collateralized debt obligations?

a. The key feature of a synthetic CDO is that SPE purchases credit protection (i.e., long CDS positions) from the originator
b. The key advantages of a cash CDO over a synthetic CDO include operational benefits, design flexibility, and management ease in the case of bankruptcies
c. A market-value CDO funds payments to note holders (investors) at least in part by selling collateral
d. A bespoke CDO is fully-funded by definition: total notional of notes issued to investors equals total notional of underlying portfolio