ARM 402 CHAPTER 1 ACTUAL PART 4 QUESTIONS

ARM 402 CHAPTER 1 (ACTUAL / ) (PART 4) QUESTIONS

AND 100% VERIFIED ANSWERS GRADE A+

Swaps - ---Answers___-an agreement between two orgs to exchange payments based on changes in the value of an asset, yield, or index over a specific period -commonly used to manage interest rate and currency rate of exchange risk -two parties will swap interest payment streams on a bond; one has fixed rate, one has variable rate -variable (floating) rate is typically tied to an index of interest rates that banks charge each other for loans

-ex: a company will make payments on a variable rate, but

receive payments on a fixed rate -swaps are frequently structured sot that no money is paid up front between couterparties for the contract -instead, cash flows are exchanged back and forth between the orgs through the term of the swap

Securitization - ---Answers___-the process of creating marketable investment securities based on a financial transaction's cash flows -can allow an org to exchange income-producing assets for cash from the purchaser of the security -- allows the org to convert the asset to cash on its balance sheet -when an org uses an intermediary to securitize, it allows investors to decide whether to invest in a security based solely on the risk presented by the income-producing asset and not 1 / 4

the credit risk of the org who owned the asset before transferring it to the intermediary -cash is more desirable because of its versatility and it does not carry credit risk -the intermediary that enables the bank to convert its mortgage receivables asset into a cash asset is called SPV -SPV securitizes the mortgage receivables by using them as collateral for securities it sells to investors; it then uses the interest and principal repayments on the mortgage receivables to fund the interest and principal repayments to the security investors -the securities carry the risks of the mortgage receivables

held by the SPV: possibility of default and risk that the

mortgagors might cancel their mortgages in order to refinance them -securitization transfers the risk inherent in the mortgage receivables from the bank to the security investors -when an SPV is involved, investors can based decisions solely on the risk presented by the income-producing assets held as collateral by the SPV; if an org directly securitized without an SPV, investors would also need to consider the overall credit risk of the org -an SPV reduces credit risk

Securitization Model - ---Answers___-org sells the income- producing assets to an SPV in exchange for cash; the income- producing assets are no longer owned by the org but by the SPV to sell to investors 2 / 4

-the investors purchase the securities for cash and receive a return on their investment commensurate with the risk inherent in the income-producing assets that back the securities, free of the org's credit risk

Securitization/SPV Regulatory Requirements - --- Answers___-regulators, auditors, and potential investors scrutinize the use of SPVs bc they have been used to manipulate org's income statements and balance sheets -therefore, firm must take utmost care to meet all reg.requirements and maintain a high level of disclosure

Contingent Capital Arrangements - ---Answers___-an agreement, entered into before any losses occur, that enables an org to raise cash by selling stock or issuing debt at prearranged terms after a loss occurs that exceeds a certain threshold -org does not transfer the risk of loss to investors, but simply receives a capital injection in the form of debt or equity to help it pay for the loss -org generally receives more favorable terms than it would if forced to raise capital after a large loss -org agreeing to provide the contingent capital receives a committment fee in exchange for its promise to provide funds to the org after a loss; fee is influenced by several factors, including likelihood of loss, interest rates of alternative investments, credit risk of org -after a loss, investors in a contingent capital arrangement become creditors of, or equity investors in, the org 3 / 4

-usually set up as an option so org who purchases the agreement is not obligated to exercise the option, even if its losses exceed the threshold specified in the agreement

-3 types of arrangements: standby credit facility, catastrophe

equity put option, contingent surplus note

Standby Credit Facility - ---Answers___-when a bank or another financial institution agrees to provide a loan to an org if the org suffers a loss -the credit is prearranged, so the interest rate and principal repayment schedule are known in advance and org pays a commitment fee -similar to insurance; they are often used together -obligates the org to pay back, with interest, a loan it uses to cover losses -losses paid by insurance do not have to be paid back -therefore, a standby credit facility entails loss retention, while insurance entails loss transfer -if an org's resulting annual losses exceed the insure premium, insurance is its best option

Catastrophe Put Option - ---Answers___-an org's right to sell equity (stock) at a predetermined price in the event of a catastrophic loss -the buyer of a catastrophe equity put option pays a commitment fee to the seller

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