AIMs: Assess the credit risks of derivatives. Describe a credit derivative, credit default swap, and total return swap. Explain how to account for credit risk exposure in valuing a swap.
Questions:
405.1. A firm has an (asset) value of $400.0 million with expected return (ROA) of 14.0% per annum and volatility of 36.0% per annum. The firm's only debt is a short-term zero-coupon bond with face value of $300.0 million due in one year. The riskless rate is 4.0%. Which is nearest to the firm's (normal returns-based) distance to default (DD)?
a. 1.0
b. 2.7
c. 3.3
d. 8.5
405.2. Per Stulz, assume a firm with value (V) writes a vulnerable European call option with exercise price (K) on a stock with price (S). Each of the following is true about this vulnerable option EXCEPT which is false?
a. If (V) and (S) are negatively correlated, the vulnerable option has greater credit risk
b. If (V) and (S) are positively correlated, the vulnerable option has less credit risk
c. The payoff of the vulnerable option is Min[Max(V, S-K), 0] and there does exist a closed-form solution
d. For the buyer, a contract that hedges the credit risk will pay Max(S-K,0) - Max[Min(V, S-K), 0]
405.3. Per Stulz, assume a market maker with a value of (M) enters a swap with a risky counterparty ("risky credit"). According to the terms of the swap, the market maker (M) will pay a fixed amount (F) in exchange for receiving a floating amount (S). Let (V) be the value of the risky counterparty. Each of the following is true EXCEPT which is false?
a. As the correlation between (V) and (S) decreases, the credit exposure from the market maker's perspective (exposure to the counterparty) increases
b. As the correlation between (M) and (S) increases, the credit exposure from the market maker's perspective (exposure to the counterparty) increases
c. At inception, an increased counterparty risk to the market maker (due to lower credit quality of the risky counterparty) can be handled with a lower value for (F)
d. The payoff to the market maker is given by -Max[F - S, 0] + Max[Min(S - F, V), 0]
Answers here:
Questions:
405.1. A firm has an (asset) value of $400.0 million with expected return (ROA) of 14.0% per annum and volatility of 36.0% per annum. The firm's only debt is a short-term zero-coupon bond with face value of $300.0 million due in one year. The riskless rate is 4.0%. Which is nearest to the firm's (normal returns-based) distance to default (DD)?
a. 1.0
b. 2.7
c. 3.3
d. 8.5
405.2. Per Stulz, assume a firm with value (V) writes a vulnerable European call option with exercise price (K) on a stock with price (S). Each of the following is true about this vulnerable option EXCEPT which is false?
a. If (V) and (S) are negatively correlated, the vulnerable option has greater credit risk
b. If (V) and (S) are positively correlated, the vulnerable option has less credit risk
c. The payoff of the vulnerable option is Min[Max(V, S-K), 0] and there does exist a closed-form solution
d. For the buyer, a contract that hedges the credit risk will pay Max(S-K,0) - Max[Min(V, S-K), 0]
405.3. Per Stulz, assume a market maker with a value of (M) enters a swap with a risky counterparty ("risky credit"). According to the terms of the swap, the market maker (M) will pay a fixed amount (F) in exchange for receiving a floating amount (S). Let (V) be the value of the risky counterparty. Each of the following is true EXCEPT which is false?
a. As the correlation between (V) and (S) decreases, the credit exposure from the market maker's perspective (exposure to the counterparty) increases
b. As the correlation between (M) and (S) increases, the credit exposure from the market maker's perspective (exposure to the counterparty) increases
c. At inception, an increased counterparty risk to the market maker (due to lower credit quality of the risky counterparty) can be handled with a lower value for (F)
d. The payoff to the market maker is given by -Max[F - S, 0] + Max[Min(S - F, V), 0]
Answers here:
