Other Derivatives Instruments

Question 1

Products of securitisation

Answer 1

May be seen as “derivatives” because they and their prices are derived from debt or other securities and are placed in a legal vehicle such as a company or trust.

Question 2

Securitisation

Answer 2

Amounts to the pooling of certain non-marketable assets that have a regular cash flow in a legal vehicle created for this purpose and the issuing by the SPV of marketable securities to finance the pool of assets.

Question 3

Credit derivatives

Answer 3

A contract where the payoffs depend partly upon the creditworthiness of one or more commercial or sovereign entities.

Question 4

3 Types of credit derivatives contracts

Answer 4

• Total return swaps
• Credit spread options
• Credit default swaps

Question 5

Total return swaps

Answer 5

Where the return from one asset is swapped for the return on another asset.

Question 6

Credit spread option

Answer 6

An option on the spread between the yields on two assets; the payoff depends on the change in the spread.

Question 7

Credit default swap

Answer 7

Bilateral contract between a protection purchaser and a protection seller that compensates the purchaser upon the occurrence of a credit event during the life of the contract.

Question 8

Forward Freight Agreements (FFAs)

Answer 8

A contract between two parties, which stipulates an agreed future freight rate for carrying commodities at sea. The contract does not involve any actual freight or any actual ships. It is an financial agreement that is cash settled.

Question 9

There is general agreement that securitisation instruments are also derivatives. True or false?

Answer 9

False. The products of securitisation may also be seen as “derivatives” because they and their prices are derived from debt or other securities that are placed in a legal vehicle such as a company or a trust. Some analysts will insist that these products are not derivatives. However, the jury is still out in this respect.

Question 10

A credit derivative may be defined as “… a contract where the payoffs depend partly upon the creditworthiness of one or more commercial or sovereign entities. True or false?

Answer 10

True

Question 11

A credit default swap offers a protection purchaser protection against the occurrence of a credit event during the life of the contract. For this
protection the protection purchaser makes a premium payment to the protection seller on the contract date when the swap is entered into. True or false?

Answer 11

False. A credit default swap is a bilateral contract between a protection purchaser and a protection seller that compensates the purchaser upon the occurrence of a credit event during the life of the contract. For this protection the protection purchaser makes periodic payments to the protection seller

Question 12

The primary objective of weather derivatives is to hedge the risk of the price of a commodity changing adversely as a result of the weather. True or false?

Answer 12

False. The primary objective of weather derivatives is to hedge volume risks, rather than price risks, that result from a change in the demand for goods due to a change in weather.

Question 13

Define securitisation.

Answer 13

Securitisation amounts to the pooling of certain non-marketable assets that have a regular cash flow in a legal vehicle created for this purpose (called a special purpose vehicle or SPV) and the issuing by the SPV of marketable securities to finance the pool of assets. The regular cash flow generated by the assets in the SPV is used to service the interest
payable on the securities issued by the SPV.

Question 14

The SPV created for the purpose of a securitisation issues 3 streams of MBS in the following manner:
• AAA rated MBS: 90% of the total
• BBB rated MBS: 7% of the total
• Unrated MBS: 3% of the total.
How is each stream generally financed? What does the descriptive name given to each stream indicate about the risk profile of each stream?

Answer 14

The AAA rated paper is usually sold to the market at a rate commensurate with its risk rating, while the BBB paper is usually purchased by one of the sponsors at an attractive rate of interest. The management company usually holds the unrated paper in portfolio, and a mixture of equity and debt finance is used to finance this company. The AAA rated paper is referred to as senior debt because it will be paid back before the other two streams.
The BBB rated paper is referred to as mezzanine debt as it is given an “in-between” position as far as pay back is concerned. It will be paid back before the unrated paper but only after the AAA paper has been paid back.
The unrated paper is referred to as subordinated debt as it is last in the queue when it comes to being paid back.

Question 15

The pricing of credit derivatives is determined with the equation:
DSP = RP = ytm – rfr.
What is the meaning of each term in this equation?

Answer 15

The terms in the credit default swap equation have the following meaning:
• DSP: The fee payable on the swap, i.e. the default swap spread.
• RP: The risk premium.
• ytm: the yield to maturity – the current market return on a reference bond.
• rfr: The risk-free rate – rate on equivalent term government bonds

Question 16

The relevant information on a credit default swap are:
• The risk free rate – rfr – is 8.9% pa on a synthetic risk-free security.
• The ytm of the reference bond is 12.2% pa.
• The DSP = 3.2% pa.
Will it pay the protection seller to short the reference bond and enter into the swap?

Answer 16

It does not pay the protection seller to short the reference bond and enter into the swap. Doing so means that the protection seller is borrowing money at 12.2% pa (the ytm at which the reference bond is sold), and investing at the rfr (8.9% pa) and earning the DSP of 3.2% pa, i.e. a loss of 100 bp.

Question 17

What is the underlying instrument for a weather derivative?

Answer 17

The underlying “instrument” or “value” in the case of temperature-related weather derivatives is Celsius-scale temperature as measured by “degree days” (DD). A DD is the absolute value of the difference between the average daily temperature and 18oC. The winter measure of average daily temperature below 18oC is called heating degree days (HDDs), and the summer measure of average daily temperature above 18oC is termed cooling degree days (CDDs).

Question 18

Why would a company use weather derivatives rather than insurance?

Answer 18

Weather derivative products offer weather-sensitive industries a risk management tool that allows them to efficiently hedge weather risks that were previously uninsurable. Weather derivatives are struck close to the mean to cover non-catastrophic events and unlike insurance they are contracts of difference, not a contract of indemnity.