Topic 10: Credit Derivatives – ABSs, CDSs, CDOs

SUGGESTED SOLUTIONS
Hull (2014) Ch. 8

8.8 Why did mortgage lenders frequently not check on information provided by potential borrowers
on mortgage application forms during the 2000 to 2007 period?
Subprime mortgages were frequently securitized. The only information that was retained
during the securitization process was the applicant’s FICO score and the Loan to Value
ratio of the mortgage.
8.9 How were the risks in ABS CDOs misjudged by the market?
Investors underestimated how high the default correlations between mortgages would be
in stressed market conditions. Investors also did not always realise that the tranches
underlying the ABS CDOs were usually quite thin so that they were either totally wiped
out or untouched. There was an unfortunate tendency to assume that a tranche with a
particular rating could be considered to be the same as a bond with that rating. This
assumption is not valid for the reasons just mentioned.
8.11 How is an ABS CDO created? What was the motivation to create ABS CDOs?

Typically an ABS CDO is created from the triple BBB rated tranches of an ABS. This is
because it is difficult to find investors in a direct way for the BBB – rated tranches of an
ABS.
8.12 Explain the impact of an increase in default correlation on the risks of the senior tranche of an
ABS. What is its impact on the risks of the equity tranche?
As default correlation increases the senior tranche of a CDO becomes more risky
because it is more likely to suffer losses. As default correlation increase the equity
tranche becomes less risky. To understand why this is so, note that in the limit when
there is perfect correlation thee is a high probability that here will be no defaults and the
equity tranche will suffer no losses.

Problem 23.11.
How does a five-year th-to-default credit default swap work. Consider a basket of 100
reference entities where each reference entity has a probability of defaulting in each
year of 1%. As the default correlation between the reference entities increases what
would you expect to happen to the value of the swap when a) and b) .
Explain your answer.

A five-year th to default credit default swap works in the same way as a regular credit
default swap except that there is a basket of companies. The payoff occurs when the th
default from the companies in the basket occurs. After the th default has occurred the
swap ceases to exist. When (so that the swap is a “first to default”) an increase in
the default correlation lowers the value of the swap. When the default correlation is zero

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there are 100 independent events that can lead to a payoff. As the correlation increases
the probability of a payoff decreases. In the limit when the correlation is perfect there is
in effect only one company and therefore only one event that can lead to a payoff.
When (so that the swap is a 25th to default) an increase in the default correlation
increases the value of the swap. When the default correlation is zero there is virtually no
chance that there will be 25 defaults and the value of the swap is very close to zero. As
the correlation increases the probability of multiple defaults increases. In the limit when
the correlation is perfect there is in effect only one company and the value of a 25th-to-
default credit default swap is the same as the value of a first-to-default swap.

23.12 How is the recovery rate of a bond usually defined? What is the formula relating the payoff on a
CDS to the notional principal and the recovery rate?
The recovery rate of a bond is usually defined as the value of the bond a few days after a
default occurs as a percentage of the bond’s face value. The payoff on a CDS is L(1 – R)
where L is the notional principal and R is the recovery rate.

23.17 “The position of a buyer of a credit default swap is similar to the position of someone who is long
a risk-free bond and short a corporate bond.” Explain this statement.
A CDS insures a corporate bond issued by the reference entity against default. Its
approximate effect is to convert the corporate bond into a risk free bond. The buyer of a
CDS has therefore chosen to exchange a corporate bond for a risk free bond. This
means that the buyer is long a risk free bond and short a similar corporate bond.

23.18 Why is there a potential asymmetric information problem in credit default swaps?
Payoffs from credit default swaps depend on whether a particular company
defaults. Arguably some market participants have more information about this
than other market participants (see Business Snapshot 23.3).