Level II Mock Exam A AM Petsas begins the session by asking the analysts to

Level ii mock exam a am petsas begins the session by

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2020 Level II Mock Exam (A) AMPetsas begins the session by asking the analysts to identify types of CDSs. Vasquez responds, “There are three types of CDS; single-name CDSs, index CDSs, and tranche CDSs. A single-name CDS is on any obligation of a specific reference entity. An index CDS allows investors to take a position on the credit risk of multiple companies, although higher credit correlations make the index CDS more expensive to purchase. Tranche CDSs also cover multiple borrowers, but losses are covered only up to a specific level.”Petsas notes that a payment from the credit protection seller to the credit protec-tion buyer is triggered whenever a credit event occurs. She asks each of the analysts to identify a credit event in the United States that will trigger a payment. The following are the responses of each analyst:Vasquez: “A declaration of bankruptcy by the reference entity is a credit event that will trigger a payment from the CDS seller.”Gorman: “If the reference entity fails to make a scheduled interest or principal payment, it is recognized as a failure-to-pay credit event.”Kumar: “A change in seniority of outstanding obligations is also recognized as a credit event that will trigger a payment by the protection seller.”To facilitate a discussion of CDS pricing and CDS trading strategies, Petsas presents the group with the information in Exhibit 1.Exhibit 1 Select CDS InformationCDSTypeCredit Spread (bps)Recovery RateTenor (yrs.)Coupon (bps)DurationCDX NA IGIndex5940%51004.76CDX NA HYIndex32830%55004.34Company ASingle-Name19425%51004.57Company ASingle-Name26640%101007.38Company BSingle-Name16540%55004.55Company BSingle-Name32640%105008.19Notes: CDX NA IG is an index of CDSs of investment-grade North American corporations. CDX NA HY is an index of CDSs of high-yield North American corporations.Petsas states, “I would like you to formulate appropriate CDS trading strategies using the information provided in the following statements:”Statement 1 “Our economists expect the US economy to strengthen over the coming year, with spreads on high-yield CDSs tightening by 100 bps and spreads on investment-grade CDSs tightening by 8 bps.”Statement 2 “Our analysts expect that the credit curve for Company A will flatten, whereas the credit curve for Company B is expected to steepen.”Statement 3 “Company A has a bond with five years to maturity with a credit risk premium of 85.40 bps, and Company B has a bond with five years to maturity with a credit risk premium of 205.60 bps.”
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