Mock B (Tang)
Item Set Rioja (The 5th item set). Question 6.
“Put structures will provide investors with some protection in the event that interest rates rise sharply, but not if the issuer has an unexpected credit event”
Is that statement not true? I realize “unexpected credit event” is a somewhat vague, but it’s a true statement nonetheless. What am I missing here?
Thanks
i believe the holder holds the credit risk and might face the negative credit event not the issuer … maybe thats the trick behind it cause other than that i still dont get whats wrong about this sentence…
Going with an extreme example, if the issuer declared bankruptcy the holder of the bond could no longer “put” the bond back to the issuer. Of course the CFAI doesn’t offer a decent explanation as to why the above answer isn’t correct.
IMO they assume that credit event will lead not only to spread increase but also to default and bankruptcy of company. In such case, the put option won’t make any change because the company is insolvent and will pay you nothing. Simply as that.
a lot of contradictions i believe. this is also the case with key rate durations, once they wrote its done by moving points along the yield curve and they assumed its wrong cause u should hold all constant except for 1 which is moved howeve in another mock they claim its correct…
No no, in case of key rate duration you should move only one rate and hold other constant. In essence, key rate duration measures impact on entire portfolio of change in particular point along the yield curve, assuming other are intact.
This doesn’t make sense though. If the issuer defaults, you won’t get your money back, which is exactly what the statement says. Put structures give investors protection from rising rates but NOT if the issuer has a credit event.
I really don’t see what’s wrong with this statement.
You are missing a clear fact that is in plain sight.
Put Structures DO offer some protection if the issuer has an unexpected credit event. This happens when the put structure is triggered by a credit event.
Read carefully on p81 of Vol 4 (2nd line of second paragraph)
I hope this will help
Ah, I suppose that makes sense. Basically, not all credit events are a default, so if it’s not severe enough, you could still get your money back.
That seems super subtle, but it does make sense.
All credit events are defaults but NOT all defaults are bankruptcy.
A credit event could be something as simple as missing out on a key ratio on the bond indenture while the issuer can still meet its interest and principal pmt obligaton. This would trigger a technical default. A put structure written on this technicality would offer some protection.