Which of the following are valid credit enhancements used for credit derivatives:

Which of the following are valid credit enhancements used for credit derivatives:

I. Overcollateralization

II. Excess spread

III. Cash reserves

IV. Margin requirements
A . I, II and IV
B . II, III and IV
C . I, II and III
D . I, II, III and IV

View Answer

Answer: C

Explanation:

Overcollateralization is when the notes issued by the special purpose vehicle are less in value compared to the underlying pool of assets, thereby providing a buffer to absorb losses. Excess spread implies that the notes issued carry a lower interest rate than the interest rate received on the underlying assets. Cash reserves are reserves intended to take first hits when losses happen. All of these are valid credit enhancements for structured products. Additionally, ‘insurance wraps’ are also used as a credit enhancement. Choice ‘c’ is the correct answer.

‘Margin requirements’ do not mean anything in this context and are not a valid credit enhancement used for credit derivatives.