EDU mock

anbu.edu
Finance Junkie
Posts: 205
Joined: Mon Feb 04, 2013 3:35 pm

EDU mock

Postby anbu.edu » Sun Nov 09, 2014 11:43 am

In a basket CDS ,the reference portfolio has 16 assets with varying credit grades of USD 0.5
million each. The portfolio holder wants to buy protection by way of basket CDS only on 5
subordinate credit exposures and leave the senior credit exposure uncovered. To arrive at the CDSpremium, you are studying the correlation relationship of the 16 exposures. Which one of the
following statements is respect of quoting CDS premium for 5 subordinate credit exposures is
correct.
Select one:
a. The premium will be more if the names in the portfolio are highly correlated .
b. The premium will be less if the names in the portfolio are highly correlated .
c. Correlation is not a relevant input in quoting premium and could be ignored.
d. The premium will be less if the names in the portfolio are negative correlated

The correct answer is B.
The subordinate grade in the reference basket is more likely to default than the seniorgrades. The
probability of default of the subordinate grade is reduced if it is more correlated with the senior
grades. Hence the premium payable will be less . All other statements, except B, are contrary
statement.

Can you explain little more clearly

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

EDU mock

Postby edupristine » Mon Nov 10, 2014 4:50 am

Hi,
Option (B) says that the premium will be less if the names of the portfolio are highly correlated.

We know that subordinate credit exposures are always relatively riskier and hence more likely to default than the senior credit exposures.

Now if all the names in the CDS basket are correlated, it means the subordinate grades are correlated with the senior grades. Now since the senior grades have a very low probability of default, correspondingly the junior or subordinate grades will have a lower PD too (This because of correlation amongst all the grades in the CDS).

Since the PD will be less, the CDS premium payable will also be lesser.


Return to “FRM Part II”



cron

Disclaimer

Global Association of Risk Professionals, Inc. (GARP®) does not endorse, promote, review or warrant the accuracy of the products or services offered by EduPristine for FRM® related information, nor does it endorse any pass rates claimed by the provider. Further, GARP® is not responsible for any fees or costs paid by the user to EduPristine nor is GARP® responsible for any fees or costs of any person or entity providing any services to EduPristine Study Program. FRM®, GARP® and Global Association of Risk Professionals®, are trademarks owned by the Global Association of Risk Professionals, Inc

CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by EduPristine. CFA Institute, CFA®, Claritas® and Chartered Financial Analyst® are trademarks owned by CFA Institute.

Utmost care has been taken to ensure that there is no copyright violation or infringement in any of our content. Still, in case you feel that there is any copyright violation of any kind please send a mail to abuse@edupristine.com and we will rectify it.