Sample Questions
Question 1
Easy
Which of the following best describes the CDS-bond basis for a given reference entity?
Solution
B is correct. The CDS-bond basis is conventionally defined as the CDS spread minus the asset swap spread (or Z-spread) of a comparable cash bond issued by the same reference entity. A non-zero basis can arise from cheapest-to-deliver optionality in physical settlement, differences in counterparty risk between cash and synthetic markets, repo and funding effects, or relative supply-demand imbalances. The basis is therefore a measure of relative value between the synthetic and cash credit markets on the same name.
Question 2
Medium
Which of the following MOST ACCURATELY characterizes the relationship between credit value adjustment (CVA) and debit value adjustment (DVA) on a bilateral derivatives portfolio?
Solution
A is correct. CVA is the market value of expected counterparty default losses on positions where the bank has positive exposure to the counterparty, that is, where the counterparty owes the bank. DVA is conceptually symmetric: it is the value to the bank of its own potential default on positions where the counterparty has positive exposure to the bank. The pair captures the bilateral nature of default risk on uncollateralized derivative books, with CVA reducing fair value and DVA, controversially, increasing it as the bank's own credit deteriorates. The construct is rooted in accounting fair value rather than regulatory capital.
Question 3
Hard
Under the Basel III bank capital framework, the conceptual distinction between Common Equity Tier 1 (CET1) capital and Tier 2 capital is MOST ACCURATELY characterized as the distinction between which of the following pairs?
Solution
B is correct. Basel III organizes regulatory capital by loss-absorption capacity. CET1 (and to a lesser extent Additional Tier 1) is designed to absorb losses while the bank remains a going concern, supporting continued operation without triggering resolution. Tier 2 instruments are subordinated debt and similar instruments that absorb losses only on a gone-concern basis, namely in resolution or liquidation, after equity and AT1 have been written down or converted. This going-concern versus gone-concern split is the organizing principle of the Basel capital stack.
