Introduction to Structuring

Question 1

1. What is the similarity between a structured product and the capital structure of an operating firm?

Answer 1

• Both are used to structure risk (and longevity). The capital structure of an operating firm is used to structure risk in the business enterprise, whereas the structure product is used to structure risk of a financial portfolio.

Question 2

2. What is the primary role of structuring in an economy?

Answer 2

• The primary economic role of structured products is usually market completion – making available a broader spectrum of investment opportunities.

Question 3

3. How could a financial market become less complete?

Answer 3

• By having a reduction in the number of unique investment opportunities or an increase in the number of uncertainties facing investors.

Question 4

4. From an investor’s viewpoint, what is the difference between owning a tranche in a sequential-pay CMO and a tranche in a targeted amortization class CMO in a rising interest rate environment?

Answer 4

• In a sequential-pay CMO the order or prepayment does not change: the senior most tranche is paid first, the next senior tranche second, and so on. In the targeted amortization class CMO the tranches receive payments in accordance with a more complex priority that changes with major changes in prepayment speeds such that various tranches may experience substantial increases or decreases in seniority in receiving cash distributions.

Question 5

5. What is the extension risk and contraction risk of the PO tranche to a CMO?

Answer 5

• Typically, principal-only tranches are positively exposed to extension risk in that their values decline when their payments extend in longevity (i.e., prepayments slow) since PO holders receive no coupons. Conversely, principal-only tranches are negatively exposed to contract risk; typically, as interest rates decline, the speed of prepayments accelerates and the values of PO’s rise.

Question 6

6. What are the two major types of investor motivations to investing in a tranche of a CMO rather than investing directly in mortgages similar to the mortgages of the CMO’s collateral pool?

Answer 6

• Risk management: Investors may be better able to manage risk through structured products (e.g., by selecting tranches with specific longevities)
• Return enhancement: Investors may be better able to establish positions that will enhance returns if the investor’s market view is superior

Question 7

7. Name two prominent time periods when structured mortgage products are believed to have increased systemic risk and led to a financial crisis? What is the major difference between the underlying economic events that led to the losses in these two crises?

Answer 7

• 1994 and 2007
• In 1994, the combination of extended maturities and higher interests caused market values of
many CMO tranches to collapse based more on interest rate risk than default risk. In 2007, the creditworthiness of the CMOs caused the market values of many tranches to fall substantially. In both situations, the dramatic fall in market values caused investors and institutions to liquidate their positions which exacerbated the crisis by lowering CMO valuations even further.

Question 8

8. In Merton’s structural model, how is debt with default risk viewed as having exposure to a put option?

Answer 8

• The risky debt of a levered firm can be viewed as being equivalent to owning a riskless bond and writing a put option that allows the stockholders to put the assets of the firm to the debt holders without further liability (i.e., in exchange for the debt).
➢ Debt of Levered Firm = + Riskless Bond – Put Option on Firm’s Assets

Question 9

9. In Merton’s structural model, what is the conflict of interest between stockholders and debt holders
   with regard to asset risk and how does this conflict relate to structured products?

Answer 9

• There is an inherent conflict between the stockholders and the bondholders with regard to the optimal level of risk for the firm’s assets. The equity holders, with their long position in a call option prefer higher levels of risk, especially when the value of the firm’s assets is near or below the face value of the debt. Conversely, bond holders prefer safer projects and reduced asset volatility as seen through their short position in a put option. The conflict of interest may be viewed as a zero sum game in which managers can transfer wealth from bondholders to stockholders by increasing the risk of the firm’s assets (or vice versa).
• The conflict of interest between stockholders and bondholders in the capital structure of a firm is analogous to the case of structured products with multiples tranches. The manager of the collateral pool can cause wealth transfers between tranches by altering the risk of the assets. In most structures, high levels of asset risk benefit junior tranche holders at the expense of senior tranche holders.

Question 10

10. What are three major option strategies that resemble the ownership of a mezzanine tranche?

Answer 10

• A collar position, a bull call spread and a bull put spread