Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 25: Credit Derivatives

Multiple Choice Test Bank: Questions with Answers

1. What is the number of companies underlying the CDX NA IG index?

A. 50
B. 75
C. 100
D. 125

Answer: D

There are 125 investment grade companies underlying CDX NA IG.

2. What is the number of companies underlying the iTraxx index?

A. 50
B. 75
C. 100
D. 125

Answer: D

There are 125 investment grade companies underlying iTraxx.

3. What is the rating of the companies underlying the iTraxx index?

A. A or above
B. BBB or above
C. BB or below
D. BBB or below

Answer: B

The companies underlying iTraxx must be investment grade. This means that their credit
ratings must be BBB or above.

4. In a CDS with a notional principal of $100 million the reference entity defaults. What is the
payoff to the buyer of protection when the recovery rate is 30%?
A. $100 million
B. $30 million
C. $130 million
D. $70 million

Answer: D

The payoff is the notional principal times one minus the recovery. In this case this is
100×(1−0.3) or $70 million.
5. In a one-year forward contract on a CDS that will last five years, what usually happens if there is
a default during the first year?
A. There is a payoff to the forward protection buyer at the time of default
B. There is a payoff to the forward protection buyer at the end of one year
C. There is a payoff to the forward protection buyer at the end of six years
D. The contract ceases to exist

Answer: D

A forward CDS contract ceases to exist if there is a default before the maturity of the
forward contract.

6. Which of the following happens when the default correlation of the companies underlying a
CDO increases?
A. The value of the senior tranche and the equity tranche to the protection buyer both
increase
B. The value of the senior tranche and the equity tranche to the protection buyer both
decrease
C. The value of the senior tranche to the protection buyer decreases and the value of the
equity tranche to the protection buyer increases
D. The value of the senior tranche to the protection buyer increases and the value of the
equity tranche to the protection buyer decreases

Answer: D

Senior tranches are more likely to experience losses and so their value to the protection
buyer increases. The equity tranche is less likely to experience losses and so its value to the
protection buyer decreases. (The total expected loss of all tranches stays the same.) This
answer is best understood by thinking about the situation where every company has a 2%
probability of defaulting. What is the situation if the correlation is zero? What is the
situation when the correlation is perfect?

7. Which of the following is true of a synthetic CDO?

A. It is created from portfolios of bonds
B. It is created from portfolios of CDSs
C. It references a standard portfolio of bonds
D. None of the above

Answer: B

A synthetic CDO is created from a portfolio of CDSs where protection has been sold on each
name.

8. A CDS with a number of reference entities provides for each reference entity a payoff if it
defaults. What is a name for this CDS?
A. Binary CDS
 B. Add-up Basket CDS
C. First-to-Default CDS
D. n-to-Default CDS

Answer: B

This is a portfolio of CDSs and is known as an add-up basket

9. Which of the following is the most popular life for a credit default swap?
A. 1 year
B. 3 years
C. 5 years
D. 10 years

Answer: C

5 years is the most popular life for a CDS

10. If the CDS spread for a regular 5-year CDS is 120 basis points, what is the CDS spread for a 5-year
binary CDS on the same underlying reference entity? Assume a recovery rate of 40%.
A. 48 basis points
B. 72 basis points
C. 200 basis points
D. 300 basis points

Answer: C

The payoff from a regular CDS is (1-R) times the payoff from a binary CDS where R is the
recovery rate. It follows that the CDS for a binary CDS is 120/(1-0.4) or 200 basis points

11. For what range of losses is the equity tranche of iTraxx (or CDX NA IG) responsible?
A. 0 to 10%
B. 0 to 7%
C. 0 to 6%
D. 0 to 3%

Answer: D

The equity tranche covers losses between 0 and 3% of the total principal

12. Which of the following is true about a CDS?

A. Restructuring is never a credit event
B. Restructuring is always a credit event
C. Certain types of restructuring qualify as credit events but others do not
D. Sometimes a CDS is defined so that restructuring is a credit event and sometimes it is
not
 Answer: D

Sometimes restructuring is included as a credit event and sometimes it is not.

13. If the CDS-bond basis is X minus Y, what are X and Y?

A. X is the CDS spread and Y is the excess of the bond yield over the swap rate
B. X is the excess of the bond yield over the swap rate and Y is the CDS spread
C. X is the CDS spread and Y is the excess of the bond yield over the Treasury rate
D. X is the excess of the bond yield over the Treasury rate and Y is the CDS spread

Answer: A

The CDS-bond basis is the excess of the CDS spread over the bond yield spread.

14. In the Lehman bankruptcy the payoff to people who had bought CDS protection was 91.375% of
the notional principal. How was this determined?
A. By calculation of the cheapest-to-deliver bond
B. By an auction process
C. By a calculation agent
D. By Lehman’s liquidators

Answer: B

An auction process is now used to determine cash payoffs on CDSs in the event of a default.

15. Which of the following best describes a total return swap?

A. It exchanges the realized return on an asset, including both income and capital
gains/losses, for a return, equal to LIBOR plus a spread on the initial value of the asset
B. It exchanges the promised return on an asset, including both income and capital
gains/losses, for a return equal to LIBOR plus a spread on the initial value of the asset
C. It exchanges the realized return on an asset, including income but not capital
gains/losses, for a return equal to LIBOR plus a spread on the initial value of the asset
D. It exchanges the promised return on an asset, including income but not capital
gains/losses, for a return equal to LIBOR plus a spread on the initial value of the asset

Answer: A

A total return swap exchanges the actual (not the promised) return on an asset for LIBOR
plus a spread.

16. If a tranche spread is 55 basis points and the fixed coupon is 60 basis points, which of the
following happens when a trader buys protection?
A. The trader pays an estimate of the present value of 5 basis points per year and then
pays 55 basis points per year
B. The trader pays an estimate of the present value of 5 basis points per year and then
pays 60 basis points per year
 C. The trader receives an estimate of the present value of 5 basis points per year and then
pays 55 basis points per year
D. The trader receives an estimate of the present value of 5 basis points per year and then
pays 60 basis points per year

Answer: D

Trading is organized so that the trader pays 60 basis points. Because the spread is actually
only 55 basis points the trader receives an estimate of the present value of 5 basis points
per year at the outset. This means that the tranche trades like a bond.

17. A portfolio of ten companies is formed. In a third-to-default swap (Circle one)

A. There is a payoff when the third default on the portfolio happens
B. There is a payoff when the first, second and third companies defaults happen
C. There is a payoff when the third, fourth, fifth…tenth companies defaults happen
D. None of the above

Answer: A

There is a payoff when the third default happens

18. The yield on a company’s five-year bonds is 5%. The five year swap rate is 4.5% and the five-year
Treasury rate is 4%. What would be closest to your best estimate of the five-year CDS spread
A. 200 basis points
B. 150 basis points
C. 100 basis points
D. 50 basis points

Answer: D

The best estimate is the excess of the bond yield over the swap rate or about 50 basis
points.

19. Gaussian quadrature is

A. A quadratic spline approximation to a normal distribution
B. A way to approximate an integral of a function of a normally distribute variable as a
sum of terms
C. A procedure for speeding up Monte Carlo simulation when credit derivatives are valued
D. An alternative to a look up table to determining values of the cumulative normal
distribution

Answer: B

Gaussian quadrature is a way of integrating over a normally distributed factor when CDOs
are valued using the Gaussian copula model. Extreme values of the factor are considered
appropriately

20. Which of the following describes “base correlation”

A. The most basic correlation measure possible
B. A correlation used to value all tranches
C. The correlation implied from market data
D. The correlation for valuing a tranche with an attachment point of 0%

Answer: D

The base correlation for X% is the correlation that would be used to value a tranche
which provides protection against the first X% of losses on a portfolio. The tranche
considered has an attachment point of 0% and a detachment point of X%.