Learning Objectives: Define CDS forwards and CDS options. Describe the process of valuing a synthetic CDO using the spread payments approach and the Gaussian copula model of time to default approach. Define the two measures of implied correlation: compound (tranche) correlation and base correlation. Discuss alternative approaches used to estimate default correlation.
Questions:
24.23.1. Global Derivatives Bank’s (GDB) risk management team is considering the utility of CDS forwards and options to tailor their risk management over time.
Given the anticipated increase in sector volatility and GDB's existing positions, which of the following strategies should the bank prioritize to manage its exposure effectively?
a. Renegotiate the CDS Forward Contract
b. Increase Holdings in CDS Options
c. Exercise the CDS Call Option Early
d. Maintain Current Positions and Monitor Market Conditions
24.23.2. Omega Capital is valuing a synthetic CDO structured to diversify its investment portfolio. The synthetic CDO comprises credit default swaps on a portfolio of 100 corporate entities, segmented into equity, mezzanine, and senior tranches. The equity tranche, which Omega Capital retains, is the first to absorb any losses up to 5% of the total CDO principal, followed by the mezzanine and senior tranches.
Omega uses the Gaussian copula model to accurately assess risk and determine the valuation of each tranche. This model helps estimate the time to default by integrating default correlations among the reference entities. The firm aims to calculate the spread payments that should be received by each tranche based on its risk exposure. Given the complexities involved in the financial markets and the intricate structure of synthetic CDOs, Omega is cautious about ensuring the accuracy of its default probability estimates and their impact on tranche valuation.
Which of the following steps should Omega Capital prioritize to effectively value its synthetic CDO using the Gaussian copula model of time to default?
a. Recalculate the Correlation Parameters
b. Adjust the Tranche Coverage Based on Updated Probabilities
c. Integrate Default Probabilities Over Standard Normal Distribution
d. Review and Adjust the Recovery Rates
24.23.3. Global Credit Solutions (GCS) is re-evaluating the implied correlation models used in its portfolio of synthetic CDOs in response to recent shifts in credit market dynamics. The portfolio is structured with various tranches based on corporate credit default swaps, and the team focuses on recalibrating both compound and base correlations, which are critical for accurate tranche valuation.
Which of the following steps should Global Credit Solutions undertake to accurately recalibrate the implied correlations in their synthetic CDO models, according to industry practices?
i. Define and recalculate the compound correlation for each tranche by adjusting the model so the spread calculated matches the market-observed spread for that tranche, using an iterative search method.
ii. Calculate the base correlation for a specific tranche by determining the compound correlations for all subordinate tranches and using these to calculate the loss up to the attachment point of the tranche in question, ensuring the model prices the tranche consistently with market data.
iii. Explore the use of alternative copula models beyond the Gaussian framework, such as Student t or Clayton copulas, which might offer a more accurate reflection of default risks under extreme market conditions.
iv. Directly use empirical market data to adjust both compound and base correlations, ensuring they reflect current market conditions and observed pricing anomalies.
a. only i
b. i and ii only
c. ii and iii only
d. iii and iv only
Answers here:
In forum
Questions:
24.23.1. Global Derivatives Bank’s (GDB) risk management team is considering the utility of CDS forwards and options to tailor their risk management over time.
- CDS Forwards: GDB entered into a forward contract to sell 5-year protection on TechCo, a major technology firm, for 300 basis points starting in one year. If TechCo defaults before the contract starts, the forward contract will be nullified.
- CDS Options: GDB purchased a CDS call option that allows the bank the right to buy 5-year protection on HealthCorp starting in one year for 250 basis points. The premium for this option was paid upfront. The market anticipates volatile health sector performance, which could impact HealthCorp's credit stability.
Given the anticipated increase in sector volatility and GDB's existing positions, which of the following strategies should the bank prioritize to manage its exposure effectively?
a. Renegotiate the CDS Forward Contract
b. Increase Holdings in CDS Options
c. Exercise the CDS Call Option Early
d. Maintain Current Positions and Monitor Market Conditions
24.23.2. Omega Capital is valuing a synthetic CDO structured to diversify its investment portfolio. The synthetic CDO comprises credit default swaps on a portfolio of 100 corporate entities, segmented into equity, mezzanine, and senior tranches. The equity tranche, which Omega Capital retains, is the first to absorb any losses up to 5% of the total CDO principal, followed by the mezzanine and senior tranches.
Omega uses the Gaussian copula model to accurately assess risk and determine the valuation of each tranche. This model helps estimate the time to default by integrating default correlations among the reference entities. The firm aims to calculate the spread payments that should be received by each tranche based on its risk exposure. Given the complexities involved in the financial markets and the intricate structure of synthetic CDOs, Omega is cautious about ensuring the accuracy of its default probability estimates and their impact on tranche valuation.
Which of the following steps should Omega Capital prioritize to effectively value its synthetic CDO using the Gaussian copula model of time to default?
a. Recalculate the Correlation Parameters
b. Adjust the Tranche Coverage Based on Updated Probabilities
c. Integrate Default Probabilities Over Standard Normal Distribution
d. Review and Adjust the Recovery Rates
24.23.3. Global Credit Solutions (GCS) is re-evaluating the implied correlation models used in its portfolio of synthetic CDOs in response to recent shifts in credit market dynamics. The portfolio is structured with various tranches based on corporate credit default swaps, and the team focuses on recalibrating both compound and base correlations, which are critical for accurate tranche valuation.
Which of the following steps should Global Credit Solutions undertake to accurately recalibrate the implied correlations in their synthetic CDO models, according to industry practices?
i. Define and recalculate the compound correlation for each tranche by adjusting the model so the spread calculated matches the market-observed spread for that tranche, using an iterative search method.
ii. Calculate the base correlation for a specific tranche by determining the compound correlations for all subordinate tranches and using these to calculate the loss up to the attachment point of the tranche in question, ensuring the model prices the tranche consistently with market data.
iii. Explore the use of alternative copula models beyond the Gaussian framework, such as Student t or Clayton copulas, which might offer a more accurate reflection of default risks under extreme market conditions.
iv. Directly use empirical market data to adjust both compound and base correlations, ensuring they reflect current market conditions and observed pricing anomalies.
a. only i
b. i and ii only
c. ii and iii only
d. iii and iv only
Answers here:
In forum
