M-LOS d Session 17 - Reading 65 Using Credit Derivatives to Enhance Return

CFA Level 2 - Derivative Investments Session 17-Reading 65 Using Credit Derivatives to Enhance Return and M-LOS d (Practice Questions, Sample Questions) 1. Which of the following most accurately describes a basis trade usingcredit default swaps? The investor: A) buys a long-term credit default swap and sells a short-term creditdefault swap.B) buys a short-term credit default swap and sells a long-term creditdefault swap. C) exploits the difference between the credit default swap premiumand asset swap spread (Explanation: In a basis trade, the credit default swap premium is compared to the asset swap spread of theunderlying bond. The latter refers to a bond’s yield above a benchmarkin a swap. This spread should reflect the credit risk of the bond. If it ishigher than the credit default swap premium, the basis is negative andthe investor would buy the bond and buy the credit default swap (buyprotection against the long position), thereby creating an arbitrageopportunity ) 2. Which of the following most accurately describes a credit curve steepener trade using credit default swaps? The investor: A) buys a short-term credit default swap and sells a long-term creditdefault swap.B) sells a credit default swap on a firm’s subordinated debt and buys acheaper credit default swap on the senior debt. C) buys a long-term credit default swap and sells a short-termcredit default swap (Explanation: In a curve trade, an investor has different opinions about the long term versus short term prospects for abond issuer. The trade can be a flattener or a steepener. In a credit

curve steepener, the investor believes that the issuer has the ability tosubsist in the short term, but that its long-term prospects are poor. Thesale of the short-term credit default swap partially finances the purchaseof the long-term credit default swap ) 3. Which of the following most accurately describes a correlation trade using credit default swaps? The investor: A) goes long a credit index and shorts specific credit default swaps. B) sells protection on a first-to-default basket of credit defaultswaps. (Explanation: In one type of correlation trade, the investor sells protection on a basket of credit default swaps. One such basket is afirst-to-default swap, where the number of credit default swaps in thebasket is typically five. In this structure, the investor would provideprotection for the first (and only the first) default. If one of the referenceobligations defaults, the investor owes the basket’s notional amount andreceives the defaulted reference obligation. The name “correlation trade”comes about because the pricing of the basket default swap depends onthe default correlation, which is the probability that two of the referenceobligations in a basket will default concurrently. Higher defaultcorrelations result in lower premiums (the protection offered by thefirst-to-default basket is worth less to the protection buyer when it islikely that several of the obligations will default at the same time) ) C) sells a credit default swap on a firm’s subordinated debt and buys acheaper credit default swap on the senior debt 4. Which of the following most accurately describes the pricing of a first-to-default basket of credit default swaps in a correlation trade? Theswap premium will be higher when the number of credit default swaps is: A) higher and when the default correlations are higher.B) lower and when the default correlations are higher. C) higher and when the default correlations are lower (Explanation: In one type of correlation trade, the investor sells protection on a basket

of credit default swaps. One such basket is a first-to-default swap, wherethe number of credit default swaps in the basket is typically five. In thisstructure, the investor would provide protection for the first (and only thefirst) default. If one of the reference obligations defaults, the investorowes the basket’s notional amount and receives the defaulted referenceobligation. The pricing of the basket default swap depends on the defaultcorrelation, which is the probability that two of the reference obligationsin a basket will default concurrently. Higher default correlations result inlower premiums (the protection offered by the first-to-default basket isworth less to the protection buyer when it is likely that several of theobligations will default at the same time). The higher the number of creditdefault swaps in the basket, the higher the basket’s premium (there is agreater probability of one of them defaulting) ) 5. Which of the following most accurately describes the characteristics of options on credit default swaps? Options on credit indices are: A) less liquid than single issuer options and in a receiver option theoption buyer has the right to buy a credit default swap.B) more liquid than single issuer options and in a receiver option theoption buyer has the right to buy a credit default swap. C) more liquid than single issuer options and in a receiver optionthe option buyer has the right to sell a credit default swap(Explanation: Options on credit indices are more liquid than single issuer options. In a receiver option, the option buyer has the right to sella credit default swap (go long the underlying) at some future date. In apayer option, the option buyer has the right to buy a credit default swap(short the underlying) at some future date. These options will change invalue as the value of the underlying changes. They can be used toprovide leverage, hedge, take a position in volatility, or to createstraddles and other option strategies )