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Hull: Options, Futures, and Other Derivatives, Ninth Edition Chapter 24: Credit Risk Multiple Choice Test Bank: Questions with Answers 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 The unconditional PD for the fourth year is 14.5% minus 10% or 4.5%. The probability of n
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  Hull: Options, Futures, and Other Derivatives, Ninth EditionChapter 24: Credit Risk Multiple Choice Test ank: !uestions ith #ns ers 1.Suppose that the cumulative probability of a company defaulting by years one, two, three and four are 3%, 6.5%, 10%, and 1.5%, respectively. !hat is the probability of default in the fourth year conditional on no earlier default #..5%$.5.0%.5.5%&.6.0% #nswer' $  (he unconditional )& for the fourth year is 1.5% minus 10% or .5%.  (he probability of no earlier default is *0%. (he )& conditional on no earlier default is therefore 0.05+0.*0.05 or 5%-.!hich of the following is usually used to dene the recovery rate of a bond #.(he value of the bond immediately after default as a percent of its facevalue$.(he value of the bond immediately after default as a percent of the sum of the bond/s face value and accrued interest.(he amount nally realied by a bondholder as a percent of face value&.(he amount nally realied by a bondholder as a percent of the sum of the bond/s face value and accrued interest#nswer' # (he recovery rate for a bond is usually dened as the value of the bond immediately after a default as a percent of its face value. (his is in spite of the fact that the bond holder/s claim in the event of a default in many  urisdictions is the face value plus accrued interest. 3.!hich of the following is true #.2is neutral default probabilities are usually much lower than real world default probabilities$.2is neutral default probabilities are usually much higher than real world default probabilities.2is neutral and real world probabilities must be close to each other if there are to be no arbitrage opportunities&.2is4neutral default probabilities cannot be calculated from &S spreads #nswer' $2is neutral default probabilities are usually greater than real world default probabilities.  .# haard rate is 1% per annum. !hat is the probability of a default during therst two years #.-.00%$.-.0-%.1.*%&.1.*6% #nswer'  (he probability of no default is e 0.017-  0.*0-. (he probability of default is one minus this or 0.01* 8i.e., 1.*%9.5.!hich of the following is true#.(he default probability per year for a company always increases as we loo further ahead$.(he default probability per year for a company always decreases as weloo further ahead.Sometimes # is true and sometimes $ is true&.(he default probability per year is roughly constant for most companies#nswer' :or investment grade companies the probability of default tends to increase with time. :or non4investment grade companies the reverse is often true.6.!hich of the following is true#.onditional default probabilities are at least as high as unconditional default probabilities $.onditional default probabilities are at least as low as unconditional default probabilities.onditional default probabilities are sometimes lower and sometimes higher than unconditional default probabilities.&.(here is no di;erence between conditional and unconditional default probabilities because a company can only default once.#nswer' # (he conditional default probability for a future time period is the unconditional default probability divided by the probability of no earlier default. (he latter is less than or e<ual to one. #s a result the conditional probability is at least as great as the unconditional probability. =.>f a company/s ve year credit spread is -00 basis points and the recovery rate in the event of a default is estimated to be -0% what is the average haard rate per year over the ve years#.0.%$.1.-%  .1.%&.-.5%#nswer' & (he average haard rate is the credit spread divided by one minus the recovery rate. >n this case we get 0.0-+0.0.0-5 or -.5% .!hich of the following is true#.2ecovery rates are lower for investment grade companies$.2ecovery rates are higher for non4investment grade companies.2ecovery rates are negatively correlated with default rates&.2ecovery rates are positively correlated with default rates#nswer' !hen default rates are high in the economy, recovery rates tends to below*.!hich of the following is true#.(he asset swap spread is a measure of e?cess of the bond yield over the @>S rate$.(he asset swap spread is a measure of e?cess of the bond yield over the A>$@2+swap rate. #n asset swap e?changes the actual return on the asset for A>$@2 plusa spread&.Bone of the above#nswer' $ (he asset swap spread is a measure of the e?cess of the bond yield over A>$@2. >n an asset swap the promised cash Cows 8not the actual cash Cows9 on a bond are e?changed for A>$@2 plus a spread10.(o be investment grade, a company has to have a credit rating of #.## or better$.# or better.$$$ or better&.$$ or better#nswer' ompanies with credit ratings of $$$ or better are investment grade.11.>n the Daussian copula model which of the following is true#.(he time to default for a company is assumed to be normally distributed. $.(he time to default for a company is assumed to be lognormally distributed  .(he time to default for a company is transformed to a normal distribution&.(he time to default for a company is transformed to a lognormal distribution#nswer'  (he time to default for each company is transformed to a normal distribution on a percentile to percentile basis and the normal distributions are assumed to be multivariate normal.1-.!hich of the following is true #.Betting always leads to a reduction in a company/s e?posure to a counterparty$.Betting always leads to a company/s e?posure to a counterparty eitherstaying the same or going down.Betting always increases a company/s e?posure to a counterparty&.Betting can increase or reduce the e?posure#nswer' $Betting means that the derivatives portfolio with a counterparty is considered to be a single transaction in the event of a default. (his cannot increase the e?posure. >f there are transactions in the portfolio with both positive and negative values the e?posure will go down.13.!hich of the following is true#. &owngrade triggers are particularly valuable if they are widely used bya company/s counterparties$. &owngrade triggers become less valuable if they are widely used by acompany/s counterparties. &owngrade triggers are useless because their impact is always anticipated by the maret&. &owngrade triggers are a two4edged sword. >f company # has a downgrade trigger for company $ then company $ has a downgrade trigger for company ##nswer' $&owngrade triggers become less valuable if many of a company/s counterparties are using them 8as was the case with Enron and #>D9. (his is because the counterparties will re<uire either cash collateral, or transactions to be unwound, at the same time. (his can caus eteh company to fail.1.!hich of the following is true of Ferton/s model'#.(he e<uity is a call option on the assets $.(he assets are a call option on the debt.(he debt is a call option on the e<uity&.(he e<uity is a call option on the debt
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