Primary economic role of structuring - ANSWER-Structured securities complete the market - structured to meet all different needs & helps investors prepare for all states of the world
MBS - ANSWER-Mortgage-backed securities - security secured by pool of mortgages (mortgages are the collateral)
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CAIA Level 1 - Topic 6 Structured Products Questions& Answers 100% Correct
Primary economic role of structuring - ANSWER-Structured securities complete the market - structured to meet all different needs & helps investors prepare for all states of the world
MBS - ANSWER-Mortgage-backed securities - security secured by pool of mortgages (mortgages are the collateral)
RMBS - Agency RMBS - ANSWER-Residential MBS - low credit risk: backed by the US government
- has prepayment risk: borrower' s right to repay mortgage early a key risk
Contraction risk - ANSWER-Average life decreases when rates fall and prepayments increase
Extension risk - ANSWER-Average life extension as rates rise and prepayments fall
CMO - ANSWER-Collaterialized Mortgage obligations - pool of mortgages are divided into tranches
- collects and sell risk exposure to contraction rick & extension risk
Sequential-pay tranches - ANSWER-Tranches retired sequentially
- senior tranches receives all principal until paid off
- all tranches receive interest
- each sequential-pay CMO tranche has a mix of contraction and extension risk
Z-tranche or accrual tranche - ANSWER-Receives no payments until sequential-pay tranches serviced
PAC CMO structure - ANSWER-- PAC tranches: principal payments guaranteed, if prepayment rates are within prescribed range
- support tranche: provides prepayment protection to PAC tranches (like a body guard)
TAC - ANSWER-targeted amortization class - like a PAC structure, but with more narrow and complex range of prepayment speeds
PO & IO strips - ANSWER-Principal-only and interest-only strips: - PO faces extension risk (rates rise and prepayment falls) - IO faces contraction risk (rates fall and prepayment up) Floating / inverse floater rate tranches - ANSWER-Linked to index such as LIBOR
Structural Credit Risk Model - ANSWER-Incorporate characteristics of the borrower: 1) structure of cash flows 2) underlying asset behavior
Morton's Structural Model - ANSWER-Determines the credit riskiness of the bond
Company issues zero coupon debt with par = K
Assets, A > K at maturity - no default & bondholders receive K
Assets, A < K at maturity - default bondholders receive A
Put-Call Parity - ANSWER-Call + Risk-free Bond = underlying Asset + Put
- no-arbitrage relationship linking option prices tp underlying
Conflict of Interest - ANSWER-Volatility of Assets UP leads to option values UP (shareholders win / bond holders lose)
Advantages and disadvantages of structural models - ANSWER-Advantages: uses liquid equity market data, prices securities that differ in seniority and with features such as conversion options
Disadvantages: potential irrational equity prices, inaccurate pricing of very short-term and very high-quality bonds, current data on liabilities may be unreliable (does not work for sovereigns)
BSM - why applied to - ANSWER-Black-Scholes model
Complete market - ANSWER-A financial market in which enough different types of distinct of distinct securities exist to meet the needs and preferences of all participants
Inverse floater tranche - ANSWER-Offers a coupon that increases when interest rates fall and decreases when interest rates rise
PAC Tranches - ANSWER-Plan Amortization Class - receive guaranteed principal payments as long as prepayment speeds remain within a predetermined range
Reduced form model - ANSWER-Focus on default probabilities based on observations of market data of similar risk securities
Expected credit loss = PD x EAD x LGD = PD x EAD X (1 - recovery rate (RR))
Advantages and disadvantages of reduced form models - ANSWER-Advantages: can be calibrated using CDS spreads, flexibility - can easily price derivatives and portfolios, -
can adjust for credit rating changes, - does not require Balance sheet information
Disadvantages: potential lack of adequate market data needed to calibrate model, sensitivity to key assumptions, limited historical default rates, no guarantee that historical default rates represent future default rates
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