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Credit Linked Notes - Chapter 4 - Quiz - YouTube
Channel: DNA Training & Consulting
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this is the fourth and final chapter of
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the module on credit link notes
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consisting of six quiz questions to test
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your understanding of the materials
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question one
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you have issued a second to default CLN
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linked to two credits with zero default
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correlation equal probabilities of
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defaulting PD and an expected recovery
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value each RV of 60% sometime later you
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need to mark to market the position and
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you are informed that first the credits
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are now deemed to be positively
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correlated second that the RV is now
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expected to be 50% and third that the PD
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for each credit has risen of these three
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changes which will be favorable to you
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and which will be unfavorable
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here are the four possible answers
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solution 2 question 1
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the diagram we saw in Chapter three is
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reproduced here and confirms that the
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issuer of the STD is long PD short RV
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and long correlation these three
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positions being highlighted involved in
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this table we know that correlation and
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PD have risen which therefore generate
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gains for the issuer while recovery
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value has fallen which also generates
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gains so the correct answer is B are
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either all three factors are favorable
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to the issuer
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question two
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you have been offered a choice between
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two FTD notes first to default notes
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each linked to a different basket of
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reference entities basket a consists of
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four reference entities each of which
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has a default probability of one percent
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and an expected recovery value of 50
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percent basket B consists of three
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reference entities each of which has a
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default probability of two percent and
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an expected recovery value of twenty
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percent
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in each basket the notional amount of
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each reference entity is $100 which is
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also the face value of each note offered
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to you
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you know that the default correlations
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in basket a are zero which basket should
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pay the highest spread here are the four
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possible answers
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solution to question two
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we remind you that when the fault
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correlation is zero the probability that
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either A or B defaults is roughly the
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sum of their individual default
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probabilities and this can be extended
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to the case with for reference entities
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such as we have for basket a
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thus the expected loss for the basket a
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linked FTD is around four times one
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percent times 1 minus the recovery value
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which is equal to two percent
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turning to the second CLN since we do
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not know the default correlations for
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basket B we will proceed to calculate
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that notes expected loss under the two
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extreme assumptions of zero default
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correlation and then 100 percent for the
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case of zero default correlation the
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basket be linked note has an expected
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loss of around three number of reference
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entities times the two percent default
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probability for each reference entity
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times 1 minus the recovery value which
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is 4.8% therefore higher than for basket
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a
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if now we turn to the case 100% default
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correlation the expected loss for the
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basket be FTD would be around two
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percent the default probability of each
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reference entity simply multiplied by
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one minus the recovery value just to
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remind you the case of 100 percent
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default correlation is the case where
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each circle in our previous than Venn
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diagrams showing the default risk of
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each entity has come to overlap
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completely the circles for the other
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reference entities and therefore there
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is no longer any distinction between the
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reference entities this calculation
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gives us a result of 1.6 percent for the
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expected loss which is lower than for
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basket a therefore the default
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correlation for basket B does affect the
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outcome and therefore the correct answer
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to this question is d as in David
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question three you buy a CL n issued
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directly by Bank rated double-a
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referring to three reference entities
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rated single a triple B and double B
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respectively which of the following
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statements is true regarding the credit
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rating of the CLN your four possible
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answers appear now
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solution to question three
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the CLN is at least as risky as a direct
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investment in the BB rated entity since
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a default by that entity hurts the
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investor in the CLN just as much as
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under the direct investment
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exposure in addition to the issuing bank
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and to the other two reference entities
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increases the investors risk but by
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moderate amounts given the relatively
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solid ratings of these entities
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therefore the maximum credit rating for
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the CLN is BB but it may be lower if the
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addition of these credit risks pulls the
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expected loss of the investment into a
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lower category or band as we call them
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earlier therefore the correct answer to
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this question is d as in David
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question 4 which of the following could
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be a reason for preferring a direct
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issue CLN over a regular bond issued by
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the same reference entity here are your
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four possible answers
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solution to question for the CLN carries
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as much credit exposure to the reference
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entity as does the regular bond if not
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slightly more so a is wrong the CLN
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carries exposure to the CLN issuer which
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the regular bomb does not so be is also
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wrong the CLN is typically less liquid
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than a regular bond so C is wrong
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finally the CL n maturity can be
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customized to be whatever the two
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parties agree so D is correct
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question five a credit link note is
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issued by an S PV which invests the
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proceeds raised in securities yielding
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LIBOR plus five then sells protection on
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Alcatel in the CDs market when the
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spread bit offer is two forty to fifty
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in basis points the annual
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administrative costs of the SPV are ten
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basis points which are paid from the
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annual cash flows received by the SPV
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assuming no other fees costs or other
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expenses to be paid what should be the
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coupon on the CLN issued by the SPV
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linked to Alcatel here are your four
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possible answers
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solution to question five this diagram
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shows the cash flows under the CLN
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including the initial transfer of $100
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from the note holder to the SPV and the
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issuance of the CLN at LIBOR plus some
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spread that we will try to determine the
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diagram goes on to reveal that the SPV
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earns LIBOR plus five from the
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securities purchased and another 240
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basis points from the Alcatel c.d.s this
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being correctly the mid side of the
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market but
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ten basis points are paid out by the SPV
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for administrative costs therefore the
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yield that the SPV could pay on the note
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is LIBOR plus five plus 240 minus ten
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all in basis points which equals LIBOR
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plus 235 and therefore the correct
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answer is a as an apple
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question six
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the one-year credit spreads for a and B
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are fifty basis points and 80 basis
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points respectively expected loss
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following a credit event is 25% for both
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you buy their one-year bonds and issue a
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one-year FTD and the one-year STD all
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structured exactly as before
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the FTD is priced at a default
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correlation of 20% while the STD is
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priced at a default correlation of 40%
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what is the economic outcome from your
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perspective you may use any worksheet
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that you like
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the four possible answers
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now appear
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solution to question six
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we must first remember that since the CD
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s spread for one year is calculated as
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PD times one minus Rd we can infer the
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default probability by dividing the
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spread by 1 minus RV we must also be
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careful to input a recovery value here
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of 75% since the question specified that
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the assumed loss following a credit
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event would be 25%
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applying now the formula above
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we can
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calculate for company a a PD of 2%
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to get the spread of 50 basis points
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mentioned in the question and for a
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company be a spread of 3.2 percent to
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get the correct CDF spread of 80 basis
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points
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pricing the FTD assuming a 20% default
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correlation indicates a spread of 1.1 6%
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while pricing the STD second to default
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assuming a 40% correlation
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indicates a spread of 26 basis points
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so the end result is that you earn 50
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basis points on your CDs on company a
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and other 80 basis points from your CD S
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on company B but payout the sum of the
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1/16 and the 0.26 that we just
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calculated the net result is a loss of
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12 basis points
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therefore the correct answer is B as in
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boy
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this completes the quiz as well as the
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entire module on credit link notes
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