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Hull: Options, Futures, and Other Derivatives, Ninth Edition Chapter 8: Securitization and the Credit Crisis of 2007 Multiple Choice Test Bank: Questions with Answers 1. Which of the following tends to lead to an increase in house prices? A. An increase in interest rates B. Regulators specifying a maximum level for the loan-to-value ratio on mortgages C. Banks reducing the minimum FICO score that borrowers are required to have D. An increase in foreclosures Answer: C An increase in interest rate
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  Hull: Options, Futures, and Other Derivatives, Ninth EditionChapter 8: Securitization and the Credit Crisis of 200 !ultiple Choice est #an$: %uestions &ith 'ns&ers 1.Which of the following tends to lead to an increase in house prices?A.An increase in interest ratesB.Regulators specifying a maximum level for the loan-to-value ratio on mortgagesC.Bans reducing the minimum ! C# score that $orrowers are re%uired tohave&.An increase in foreclosures Answer' CAn increase in interest rates tends to lower house prices $ecause $uyers have higher (nancing costs. )imiting the loan-to-value ratio means that some potential $uyers cannot get the mortgages they re%uire and there isless demand for houses with the result that prices tend to decline. An increase in foreclosures increases supply and this also lowers prices. *owever+ if $ans relax their lending standards ,e.g. $y reducing the minimum ! C# scores they re%uire demand should increase $ecause more people can get mortgages. As a result prices will increase. .Which of the following is true of a non-recourse mortgage? A./he house $uyer+ if una$le to mae payments+ can lose all his or her possessions B./he house $uyer has an American-style put option on the houseC./he house $uyer has a 0uropean-style put option on the house&./he lender is less liely to lose money on the mortgage Answer' B n a non-recourse mortgage a lender cannot seie other assets of the $orrower $esides the house in order to $e repaid. /his means that if the price of the house declines $elow the $alance outstanding on the mortgage the $orrower can in principle give the house to the lender in return for tearing up the mortgage. /he $orrower therefore has an American style put option to sell the house for the amount outstanding on the mortgage.2.Which of the following is 3#/ trueA./he $onus structure at $ans can lead to short-term horions for decision maingB.4ecuritiation involves the transfer of risC./he term 5agency costs6 descri$es the situation where the incentives of two parties in a $usiness relationship are not perfectly aligned&.Correlations decrease in stressed maret conditions Answer' &  A+ B+ and C are true. & is not $ecause correlations tend to increase+ not decrease+ in stressed marets+7.4uppose that AB4s are created from portfolios of su$prime mortgages with the following allocation of the principal to tranches' senior 89:+ meanine 19:+ and e%uity 19:. ,/he portfolios of su$prime mortgages have the same default rates. An AB4 C&# is then created from the meanine tranches with the same allocation of principal. )osses on the mortgage portfolio prove to $e1;:. What+ as a percent of tranche principal+ are losses on the meanine tranche of the AB4A.<9:B.;9:C.89:&.199: Answer' B19: out of the 1;: loss is a$sor$ed $y the e%uity tranche. /he remaining ;: is a$sor$ed $y the meanine tranche. /he total sie of the meanine tranche is 19:. t is therefore ;9: wiped out. <.4uppose that AB4s are created from portfolios of su$prime mortgages with the following allocation of the principal to tranches' senior 89:+ meanine 19:+ and e%uity 19:. ,/he portfolios of su$prime mortgages have the same default rates. An AB4 C&# is then created from the meanine tranches with the same allocation of principal. )osses on the mortgage portfolio prove to $e1;:. What+ as a percent of tranche principal+ are losses on the meanine tranche of the AB4 C&#A.<9:B.;9:C.89:&.199:Answer' &As the answer to the previous %uestion shows+ the meanine tranches are ;9: wiped out. /he (rst 19: out of this ;9: is a$sor$ed $y the e%uity tranche of the AB4 C&#. /he next 19: is a$sor$ed $y the meanine tranche of the AB4 C&#. /he remaining 79: is a$sor$ed $y the senior tranche of the AB4 C&#. /he meanine tranche of the AB4 C&# is therefore 199: wiped out;.4uppose that AB4s are created from portfolios of su$prime mortgages with the following allocation of the principal to tranches' senior 89:+ meanine 19:+ and e%uity 19:. ,/he portfolios of su$prime mortgages have the same default rates. An AB4 C&# is then created from the meanine tranches with the same allocation of principal. )osses on the mortgage portfolio prove to $e1;:. What+ as a percent of tranche principal+ are losses on the senior tranche of the AB4 C&#A.<9:  B.;9:C.89:&.199: Answer' AAs the answer to the previous %uestion shows the senior tranche of the AB4 C&# a$sor$s 79: losses. t is therefore 79:=89: or <9: wiped out.>.A  lost money $ecauseA. t $ought tranches created from mortgages B. t invested heavily in real estateC. t invested heavily in the stoc maret&. t insured AAA tranches of AB4 C&#s Answer' &A  insured the AAA tranches of AB4 C&#s. 8.Which of the following survived the crisis without declaring $anruptcy or $eing taen over $y another (nancial institution? A.Bear 4tearnsB.@organ 4tanleyC.)ehman Brothers&.@errill )ynch Answer' B@organ 4tanley survived. Bear 4tearns was taen over $y @organ and @errill )ynch was taen over $y Ban of America. )ehman Brothers of course declared $anruptcy..What are teaser ratesA. nterest rates that appear lower than they are B. nterest rates that depend on ) B#RC. nterest rates on mortgages with a very long amortiation period&. nterest rates that apply only for the (rst two or three years Answer' & /easer rates are low interest rates that apply for the (rst two or three years of a mortgage. 4ome house purchasers felt that they could aDord mortgage payments $ased on teaser rates and it was hoped $y $oth $orrower and lender that re(nancing would $e possi$le at the end of the teaser rate period.19.Which of the following descri$es the waterfall typically used for mortgages pre-crisis?A.A distri$ution of cash Eows to tranches with priority given to tranche  with the highest ratingB.A distri$ution of cash Eows to tranches in proportion to their outstanding principalsC.A distri$ution of losses to tranches so that tranches $ear losses in proportion to their outstanding principals&.3one of the a$ove Answer' A /he eDect of the waterfall was usually that repayments went (rst to the most senior ,highest rated tranche+ then to the next-most-senior tranche+ and so on11. n 998 the /0& spread reached a high of A.A$out 1<9 $asis pointsB.A$out <9 $asis points C.A$out 7<9 $asis points&.A$out <<9 $asis points Answer' C /he /0& spread is the spread $etween the three-month ) B#R rate and the three-month /reasury rate. t reached a$out 7<9 $asis points. 1.Which of the following were introduced $efore the credit crisis that started in 99>A.Basel B.&odd-!ranC.Basel &.Re%uirements for living wills Answer' ABasel was (rst proposed in 1 and implemented in most parts of the world in a$out 99>. /he others were introduced after the crisis had started.12.Which of the following is true as the correlation $etween mortgage defaults increases?A.0%uity tranches are almost certain to incur lossesB.4enior tranches $ecome more liely to incur lossesC./he expected num$er of defaults increases&.0%uity tranches are unaDected Answer' B f the correlation $etween mortgage defaults is very low the senior tranche is safe+ $ut as the correlation increases it $ecomes more liely that it will experience losses. 4uppose that the default pro$a$ility is :. When correlation is ero+ we expect roughly : of mortgages to default
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