Section B - Derivatives

What is a derivative in finance?

A financial contract whose value is derived from an underlying asset such as stocks, bonds, loans, or interest rates.

Why do derivatives exist in incomplete markets?

To transfer risk, enable arbitrage, and facilitate trades that wouldn't occur under asymmetric information or illiquidity.

What happens in a complete, perfect market regarding derivatives?

Derivatives are redundant since any payoff can be replicated using underlying assets.

What are the features of a perfect market?

No transaction costs, perfectly liquid, no bid-ask spread, complete markets, and perfect information.

What does the Milgrom & Stokey "No-Trade Theorem" state?

No trade will occur based solely on private information, as trade offers reveal information and revise beliefs.

What is an Asset-Backed Security (ABS)?

A tradable security backed by pooled loans like student debt, leases, or credit card receivables.

How do Mortgage-Backed Securities (MBS) differ from ABS?

MBS are backed specifically by mortgage loans.

Why are ABS and MBS useful?

They convert illiquid individual claims into tradable instruments, enabling capital flows and credit creation.

What is a Credit Default Swap (CDS)?

A derivative where the seller compensates the buyer in case of loan default or credit event.

What is a "naked CDS"?

A CDS purchased without owning the underlying loan—effectively a speculative position on default.

How did CDS markets grow unsustainably before the crisis?

The notional value of CDS contracts vastly exceeded the value of the underlying loans, creating systemic leverage.

What is a Collateralised Debt Obligation (CDO)?

A structured debt instrument pooling fixed-income assets and divided into tranches of varying risk.

What's the difference between a cash and synthetic CDO?

Cash CDOs hold actual debt assets; synthetic CDOs use CDS to gain exposure to those assets.

What are tranches in a CDO structure?

Slices of a CDO with different risk levels: senior (safest), mezzanine, and equity (riskiest).

How do derivatives reallocate returns over different states of the world?

They enable risk-sharing and speculation by transferring potential losses (or gains) under certain conditions to other parties.

What happens to systemic risk when many entities hedge with derivatives?

Risk may concentrate in hidden ways, increasing fragility (Taleb's fragility thesis).

How do attachment/detachment points in tranches spread losses?

Lower tranches absorb initial losses; higher tranches are only affected if losses exceed specific thresholds.

What does a copula model do in pricing structured products like CDOs?

Models correlation between default probabilities across assets, assuming a joint multivariate distribution.

Why was the Gaussian copula model problematic?

It understated tail risk and assumed a single correlation across tranches, ignoring actual structural dependencies.

What is the role of ratings agencies in evaluating derivatives?

They assess credit risk and assign ratings that determine regulatory eligibility and investor perception.

What was a key issue with ratings agencies pre-2008?

Conflict of interest due to issuer-pays model and competition for business, leading to inflated ratings.

How do agency problems affect derivative markets?

Fund managers may take excessive risks because they don't bear full consequences—especially with short-term incentives.

How did CDO structuring encourage poor lending standards?

Lenders could sell loans into securitisations, offloading risk and encouraging volume over quality.

What role did political incentives play in the crisis?

Policies promoted lending to low-income households, pressuring institutions to approve risky loans.

What is network contagion in derivative markets?

A default in one institution causes cascading defaults across interconnected firms via CDS contracts.

What does "Too Central To Fail" mean in network theory?

Institutions highly connected in financial flows become critical to system stability, encouraging moral hazard.

How do CDS contracts amplify network fragility?

They link institutions across obligations—failure of one disrupts many others, propagating systemic shocks.

What are margin spirals and how do they relate to systemic risk?

Falling asset prices trigger forced sales (margin calls), leading to more price drops and a feedback loop.

What is the purpose of a Special Purpose Vehicle (SPV) in securitisation?

To isolate risk and remove assets from the originator's balance sheet, often with fewer legal/regulatory constraints.

How does securitisation convert illiquid assets into tradable securities?

By pooling them into an SPV and issuing ABS or CDOs backed by the asset pool.

What are the risk allocation rules within a securitised product?

Losses are absorbed in order: equity tranche → mezzanine → senior.

What is the "bottom-up" approach to CDO valuation?

Starts with individual asset default probabilities and correlations (e.g., copula model) to estimate tranche outcomes.

What is the "top-down" approach to CDO valuation?

Begins with the aggregate loss distribution and derives implications for tranche performance.

Why were Gaussian copula models used for CDOs?

They enabled pricing of complex instruments by modelling default correlations in a mathematically tractable way.

What is the main flaw in assuming one correlation for all tranches in a copula model?

It ignores the fact that correlation risk changes across attachment/detachment points—leading to pricing distortions.

What does "tail dependence" mean and why is it problematic?

The copula assumes extreme joint defaults are rare; this understates systemic risk and fat-tail events.

How did belief in historical safety of CDOs contribute to crisis mispricing?

It led to underweighting of weak signals of emerging risk—described as a "conspiracy of optimism."

What role did teaser-rate mortgages play in the 2008 crisis?

After teaser rates expired, many borrowers defaulted → dumped homes on the market → falling MBS values → institutional losses.

How did asset price signals mislead lenders pre-crisis?

High-value home sales continued while low-value home transactions vanished from data, masking falling affordability.

What was the outcome when MBS values dropped?

Collateral backing financial institutions evaporated → network contagion → institutional failures → recession.

How did regulatory gaps contribute to the crisis?

Lack of oversight of ratings agencies and low capital requirements for CDS sellers like AIG allowed massive unchecked exposure.

What is "compression" in CDS markets?

A process where overlapping CDS contracts are replaced with simpler net exposures, reducing notional volume and risk.

What was the role of central counterparties after the crisis?

They became key in managing counterparty risk and clearing trades, improving systemic stability.

What is the difference between single-name and multi-name CDS?

Single-name CDS insures against one entity's default; multi-name CDS references a basket or portfolio of entities.

Why are multi-name CDS more complex to price?

They require modelling joint default probabilities across multiple names, increasing systemic and model risk.