Structured Products

Question 1

Equilibrium Models of term structure

Answer 1

First generation. Make assumptions about structure of FI markets and use economic reasoning to model bond prices.

Vasickek - drawback is that it allows IR to be negative. Single factor model, short term rates drift towards a prespecified long term mean. ALL bond prices are driven by the short term rate.

CIR - mean reverting model of short term rates, but IR can’t be negative. As rates approach zero, their vol approaches zero.

Question 2

Unbiased expectation hypothesis

Answer 2

All expected short term rates of bonds that are free from credit risk are assumed to be the same.

Question 3

Arbitrage free models. Second generation.

Answer 3

Ho and Lee - argues that bond prices should not allow arb opportunities. Assumes short term IR follows a normally distributed process.

Question 4

Caps, Floors

Answer 4

Values of interest rate caps and floors is equal to sum of caplets and floorlets respectively. Can be valued using black-scholes

Cap: pays reference rate above predetermined rate, cap rate or strike price. Is a series of caplets.
Reference rate - strike rate X notional / m (eg. 4 if settled quarterly).

Floor: opposite, strike rate - reference rate

Question 5

Callable bonds

Answer 5

Usually callable at a premium

Question 6

Recourse loan

Answer 6

Credit card or auto loan, borrower is personally liable for repaying outstanding balance

Question 7

Non recourse loan

Answer 7

Only allow the lender to collect the collateral at hand

Question 8

Credit enhancements

Answer 8

Can be internal, external or a combination of both and are required to have higher credit ratings.
Overcollateralisation on an ABS is a credit enhancement.

Question 9

Cat bonds

Answer 9

If no credit losses occur, investor receives all coupon payments and principal.

If event does occur, they can lose some coupons and partial or total loss of principal.

Assets held in RISK FREE assets

Floating rate and coupons are quarterly

Question 10

Attachment probability

Answer 10

Based on historical information about natural disasters and includes estimated probability that a cat bonds attachment point will be hit.

Question 11

Exhaustion point

Answer 11

Levels of claims loss at which the principal is exhausted and investors are not legally responsible for additional claims.

Question 12

Mezzanine debt can be:

Answer 12

Subordinated, unsecured debt, convertible, subordinated debt and redeemable preferred stock.

Can have some control over board, which senior debt does not.

Question 13

PPPs

Answer 13

Invested risk capital is borne exclusively by the private partner, not public partner.

Each participant can negotiate on its own behalf.