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3、An investor purchases 300,000 of ABC Corps bonds with an annual coupon of 8% and maturity of 5 years. The yield is 8% so the bonds are selling at par. The total notional amount of the bonds is $10,000,000. The investor hedges 80% of the position by becoming a total rate of return swap (TROR) payer. ABC’s computer system is hacked and the firm’s bonds decrease in price from $100 to $90. What is the payoff to the TROR total rate of return swap due to the increase in operations risk?

A) $3,000,000.

B) $2,100,000.

C) $2,400,000.

D) $1,700,000.

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The correct answer is C

The loss on the investor’s bond position is $3,000,000. The investor has hedged 80% of the position, so they will receive 80% of $3,000,000 or $2,400,000.

($90-$100) x 300,000 = $3,000,000 x 80% =$2,400,000

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4、The buyer of a credit default swap (CDS):

A) receives periodic payments after default equal to the promised payments on the defaulted bond. 

B) assigns the coupon payments from the loan to the issuer of the swap in exchange for a stated (but somewhat lower) string of guaranteed payments. 

C) makes periodic payments to the seller of the swap until a default occurs. 

D) makes a single payment to the seller of the swap at inception of the swap. 

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The correct answer is C

The buyer of the CDS makes periodic payments to the seller until a credit event such as a default occurs.

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The correct answer is B

Statements II and IV are true. Statement I is only true for CreditRisk+. Statement II is a characteristic of CreditMetrics and the KMV models. Statement III is a weakness of all portfolio credit models. Statement IV is a characteristic and major advantage of the KMV model.

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AIM 9: Assess the credit risks of derivatives.

1、ADC Inc. enters into a plain vanilla interest rate swap contract with Betax Inc. At the 3rd settlement date, ADC is owed $2.5 million but is unable to enforce the contract due to a technicality. This is an example of:

A) contract risk.

B) legal risk.

C) business risk.

D) credit risk.

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The correct answer is B

Legal risk is the risk of loss due to legal or regulatory issues. Most legal risk issues are a direct result of being unable to enforce contracts.

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2、A credit default swap does NOT hedge against which of the following risks?

A) Default risk.

B) Market.

C) Credit Deterioration.

D) Operations risk.

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The correct answer is D

The Poisson distribution is not part of CreditMetrics. The first step consists of the gathering of inputs. The gathering includes calculating many measures such as probability of default, recovery rate statistics, factor correlations and their relationships to the obligors, yield curve data, and individual exposures that are distinct from the other inputs.

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3、Which of the following is (are) a characteristic of the KMV model?

I.           Each obligor has its own sensitivity to each of the common risk factors.

II.         The model produces a VAR measure.

III.        It includes current economic conditions.

IV.      It includes an estimate of correlation between firm values based on the correlation between observed equity values.

A) I only.

B) II and IV only.

C) II only.

D) I, II, III, and IV.