CDO Structuring of Credit Risk

Question 1

1. How would the exposure to credit risk of the most senior and most junior tranches of a CDO tend to compare to the average credit risk of the collateral pool?

Answer 1

• In one sense the tranches should have credit risks that are dispersed above and below the credit risk of the underlying assets. The amount of credit risk in the senior tranches would be lower than in the collateral pool. The credit risk of the most junior tranche would be higher than the credit risk of the collateral pool. Diversification and credit enhancements make the relationship complex.

Question 2

2. List two major economic motivations to the CDO structuring of non-investment grade debt.

Answer 2

• Risk management: Investors may be better able to manage risk through structured products by selecting tranches that match their preferences.
• Return enhancement: Investors may be better able to establish positions that will enhance returns if the investor’s market view is superior

Question 3

3. What is the weighted average rating factor (WARF) of a portfolio?

Answer 3

• The weighted average rating factor (WARF) as described by Moody’s is a numerical scale from 1 (for AAA-rated credit risks) to 10,000 (the worst credit risks) that reflects the estimated probability of default.

Question 4

4. What is the primary difference between the motivations of creating a balance sheet CDO and creating an arbitrage CDO?

Answer 4

• Balance sheet CDOs are created to assist a financial institution in divesting assets from its balance sheet. Arbitrage CDOs are created to attempt to exploit perceived opportunities to earn superior profits through money management.

Question 5

5. What is the primary difference between a cash-funded CDO and a synthetic CDO?

Answer 5

• The distinction focuses on whether the SPV obtains the risk of the portfolio using actual (cash) holdings of assets or through derivative positions. A cash-funded CDO holds the portfolio of risky securities as collateral for the trust, whereas the synthetic CDO obtains the risk exposure through the use of a credit derivative.

Question 6

6. Is subordination an internal or external credit enhancement?

Answer 6

• It is an internal credit enhancement involving the structure of the product.

Question 7

7. How many tranches can be in a single-tranche CDO?

Answer 7

• In a single-tranche CDO, the CDO may have multiple tranches but the sponsor issues (sells) only one tranche from the capital structure to an outside investor.

Question 8

8. Suppose that the total value of the collateral pool of a CDO remains constant but the riskiness of the pool increases. If the value of the senior-most tranches decreases, what should happen to the combined value of the other tranches?

Answer 8

• The combined value of the other tranches will increase.

Question 9

9. What is the explanation based on option theory as to why the junior-most tranche of a CDO would fall
   in value when the collateral pool of assets becomes more diversified?

Answer 9

• The junior-most tranche of a CDO is similar to a long call position on the collateralized asset. As the collateral pool of assets becomes more diversified, thus less risky, the value of the long call position declines due to its negative vega.

Question 10

10. What is the primary purpose of using a copula approach to analyze a CDO?

Answer 10

• To ascertain the risks of tranches due to potential default risk in the CDO portfolio