Answer key by juanagui

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									                                                                                                                                      Interest Rate Collar
Q1      Date            Collar               Corridor                 Part Cap                                 Interest Exposure     Sell Floor       Buy Cap     Net Exposure
                                                                                                                     LIBOR              6%               10%
     1/1/2008           6.07%                 6.07%                    7.42%
     1/1/2009           7.62%                 7.62%                    7.89%                                       6.07%               0.00%           0.00%        6.07%
     1/1/2010           6.00%                 5.84%                    7.35%                                       7.62%               0.00%           0.00%        7.62%
     1/1/2011           6.00%                 5.02%                    7.11%                                       5.84%               -0.16%          0.00%        6.00%
     1/1/2012           6.00%                 5.89%                    7.37%                                       5.02%               -0.98%          0.00%        6.00%
     1/1/2013           9.73%                 9.00%                    8.00%                                       5.89%               -0.11%          0.00%        6.00%
     1/1/2014          10.00%                 9.00%                    8.00%                                       9.73%               0.00%           0.00%        9.73%
     1/1/2015          10.00%                 10.19%                   8.00%                                       10.62%              0.00%           0.62%        10.00%
     1/1/2016          10.00%                 9.03%                    8.00%                                       12.19%              0.00%           2.19%        10.00%
     1/1/2017           6.15%                 6.15%                    7.45%                                       11.03%              0.00%           1.03%        10.00%
                                                                                                                   6.15%               0.00%           0.00%        6.15%

        12.00%

        10.00%                                                                                                                        Interest Rate Corridor
                                                                                                               Interest Exposure      Buy Cap          Sell Cap   Net Exposure
         8.00%                                                                                                       LIBOR               9%               11%
                                                                                   Collar
         6.00%                                                                     Corridor                        6.07%               0.00%           0.00%        6.07%
                                                                                   Part Cap                        7.62%               0.00%           0.00%        7.62%
         4.00%                                                                                                     5.84%               0.00%           0.00%        5.84%
                                                                                                                   5.02%               0.00%           0.00%        5.02%
         2.00%                                                                                                     5.89%               0.00%           0.00%        5.89%
                                                                                                                   9.73%               0.73%           0.00%        9.00%
         0.00%                                                                                                     10.62%              1.62%           0.00%        9.00%
                2008 2009 2010 2011 2012 2013 2014 2015 2016 2017                                                  12.19%              3.19%           -1.19%       10.19%
                                                                                                                   11.03%              2.03%           -0.03%       9.03%
                                                                                                                   6.15%               0.00%           0.00%        6.15%

Q2   The fact that the notional amount is not the amount actually traded, and that only a percentage
     of the notional amount is traded does not answer the question as to why the credit derivative market
     (notional value) can be larger than the bond market. The main idea is that there can be derivatives on                            Participating Cap
     multiple underlying assets, multiple derivatives on a single underlying asset, and derivatives on other   Interest Exposure   70% Cap at 8%                  Net Exposure
     derivatives. Furthermore, the underlying asset need not be a bond.                                              LIBOR              8%

     Below are some good answers people have come up with:                                                         6.07%               -1.35%                        7.42%
                                                                                                                   7.62%               -0.27%                        7.89%
     There can be multiple credit derivatives on a single underlying asset (in this case a bond). So for any       5.84%               -1.51%                        7.35%
     particular bond there may be any number of credit derivatives based on it. The bonds themselves are           5.02%               -2.09%                        7.11%
     limited to the amount that are issued. Therefore, the credit market may be much larger than the               5.89%               -1.48%                        7.37%
     market of the underlying asset.                                                                               9.73%               1.73%                         8.00%
                                                                                                                   10.62%              2.62%                         8.00%
     … derivatives such as credit index swaps have an arbitrary notional amount that does not represent            12.19%              4.19%                         8.00%
     any one specific bond or set of bonds. From this, CDS and CITs can overlap in a sense and back                11.03%              3.03%                         8.00%
     more value than is actually represented in the bond market. Furthermore another type of credit                6.15%               -1.30%                        7.45%
     derivative is the collateralized debt obligation (CDO) which is just a represntation of a "pool" of any
     kind of debt - not necessarily bonds. On top of that CDS and CITs could be written to hedge CDOs,
       further raising the notional value of credit derivatives. Through all these issues, the credit derivatives
       combined notional value is immense, and since is only in part tied to the bond market, it doesn't have
       to be of lesser value.

       … collateralized debt obligations (CDOs) are actually pools of debt, which does not purely consist of
       bonds, so therefore the notional amount for CDOs does not directly related to the bond market.


Q3 A   The company can buy protection on the debt it holds, transfering it away to other investors
       The company can sell protection for a premium which can enhance the return on their investment portfolio
       Credit derivatives can be used to align the company's credit risk exposure with its desired credit risk profile
       Credit derivatives can be more flexible and less expensive than transacting in cash securities

Q3 B   The bond insurers entered into a market with which they were not familiar. They accepted credit risk
       that was correlated with the risk on the municipal bonds they were already underwriting.
       They priced the credit risk on debt securities too low for the exposure they faced.
       They overexposed themselves to an increase in the default rate.

								
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