Fundamentals of Futures and Options Markets, 8e (Hull)

Chapter 23 Credit Derivatives

1) Suppose that the cumulative probability of a company defaulting by years one, two, three and
four are 3%, 6.5%, 10%, and 14.5%, respectively. What is the probability of default in the fourth
year conditional on no earlier default?
A) 4.5%
B) 5.0%
C) 5.5%
D) 6.0%
Answer: B

2) What is the number of companies underlying the CDX NA IG index?

A) 50
B) 75
C) 100
D) 125
Answer: D

3) What is the number of companies underlying the iTraxx index?

A) 50
B) 75
C) 100
D) 125
Answer: D

4) What is the rating of the companies underlying the iTraxx index?

A) A or above
B) BBB or above
C) BB or below
D) BBB or below
Answer: B

5) In a CDS with a notional principal of $100 million the reference entity defaults. What is the
payoff to the buyer of protection when the recovery rate is 30%?
A) $100 million
B) $30 million
C) $130 million
D) $70 million
Answer: D

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6) In a one-year forward contract on a CDS that will last five years, what usually happens if there
is a default during the first year?
A) There is a payoff to the forward protection buyer at the time of default
B) There is a payoff to the forward protection buyer at the end of one year
C) There is a payoff to the forward protection buyer at the end of six years
D) The contract ceases to exist
Answer: D

7) Which of the following is usually used to define the recovery rate of a bond?
A) The value of the bond immediately after default as a percent of its face value
B) The value of the bond immediately after default as a percent of the sum of the bond's face
value and accrued interest
C) The amount finally realized by a bondholder as a percent of face value
D) The amount finally realized by a bondholder as a percent of the sum of the bond's face value
and accrued interest
Answer: A

8) Which of the following is true?

A) Risk neutral default probabilities are usually much lower than real world default probabilities
B) Risk neutral default probabilities are usually much higher than real world default probabilities
C) Risk neutral and real world probabilities must be close to each other if there are to be no
arbitrage opportunities
D) Risk-neutral default probabilities cannot be calculated from CDS spreads
Answer: B

9) Which of the following happens when the default correlation of the companies underlying a
CDO increases?
A) The value of the senior tranche and the equity tranche to the protection buyer both increase
B) The value of the senior tranche and the equity tranche to the protection buyer both decrease
C) The value of the senior tranche to the protection buyer decreases and the value of the equity
tranche to the protection buyer increases
D) The value of the senior tranche to the protection buyer increases and the value of the equity
tranche to the protection buyer decreases
Answer: D

10) Which of the following is true of a synthetic CDO?

A) It is created from portfolios of bonds
B) It is created from portfolios of CDSs
C) It references a standard portfolio of bonds
D) None of the above
Answer: B

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11) A CDS with a number of reference entities provides a payoff when any of the reference
entities defaults. What is a name for this CDS?
A) Binary CDS
B) Add-up Basket CDS
C) First-to-Default CDS
D) n-to-Default CDS
Answer: B

12) Which of the following is the most popular life for a credit default swap?
A) 1 year
B) 3 years
C) 5 years
D) 10 years
Answer: C

13) A hazard rate is 1% per annum. What is the probability of a default during the first two
years?
A) 2.00%
B) 2.02%
C) 1.98%
D) 1.96%
Answer: C

14) If the CDS spread for a regular 5-year CDS is 120 basis points, what is the CDS spread for a
5-year binary CDS on the same underlying reference entity? Assume a recovery rate of 40%.
A) 48 basis points
B) 72 basis points
C) 200 basis points
D) 300 basis points
Answer: C

15) For what range of losses is the equity tranche of iTraxx (or CDX NA IG) responsible?
A) 0 to 10%
B) 0 to 7%
C) 0 to 6%
D) 0 to 3%
Answer: D

16) Which of the following is true about a CDS?

A) Restructuring is never a credit event
B) Restructuring is always a credit event
C) Certain types of restructuring qualify as credit events but others do not
D) Sometimes a CDS is defined so that restructuring is a credit event and sometimes it is not
Answer: D

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17) If the CDS-bond basis is X minus Y, what are X and Y?
A) X is the CDS spread and Y is the excess of the bond yield over the swap rate
B) X is the excess of the bond yield over the swap rate and Y is the CDS spread
C) X is the CDS spread and Y is the excess of the bond yield over the Treasury rate
D) X is the excess of the bond yield over the Treasury rate and Y is the CDS spread
Answer: A

18) In the Lehman bankruptcy the payoff to people who had bought CDS protection was
91.375% of the notional principal. How was this determined?
A) By calculation of the cheapest-to-deliver bond
B) By an auction process
C) By a calculation agent
D) By Lehman's liquidators
Answer: B

19) Which of the following best describes a total return swap?

A) It exchanges the realized return on an asset, including both income and capital gains/losses,
for a return, equal to LIBOR plus a spread on the initial value of the asset
B) It exchanges the promised return on an asset, including both income and capital gains/losses,
for a return equal to LIBOR plus a spread on the initial value of the asset
C) It exchanges the realized return on an asset, including income but not capital gains/losses, for
a return equal to LIBOR plus a spread on the initial value of the asset
D) It exchanges the promised return on an asset, including income but not capital gains/losses,
for a return equal to LIBOR plus a spread on the initial value of the asset
Answer: A

20) If a tranche spread is 55 basis points and the fixed coupon is 60 basis points, which of the
following happens when a trader buys protection?
A) The trader pays an estimate of the present value of 5 basis points per year and then pays 55
basis points per year
B) The trader pays an estimate of the present value of 5 basis points per year and then pays 60
basis points per year
C) The trader receives an estimate of the present value of 5 basis points per year and then pays
55 basis points per year
D) The trader receives an estimate of the present value of 5 basis points per year and then pays
60 basis points per year
Answer: D

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