Say what SPVs, DPCs (derivatives product companies), monolines and CDPCs (credit derivatives product companies) are, and set out why they are limited as means of mitigating risk.
The idea
A special purpose vehicle, or SPV, is a separate legal entity created to hold assets or take risk and isolate it from a sponsor. A derivatives product company, or DPC, is a highly rated, ring-fenced subsidiary of a dealer that faces clients and hedges back to its parent. Clients can therefore trade with a counterparty better rated than the parent. A monoline is an insurer that guarantees the payment of bond principal and interest, notably on structured credit. A credit derivatives product company, or CDPC, sells credit protection against a leveraged portfolio funded with thin capital. They fall short as risk mitigants because capital is small compared with the notional protected, risk is concentrated in one sector, and losses arrive together with the downgrades that remove their value. Collateral is also often not posted. Exam point: such protection fails exactly when it is needed.
A practice question
What is a special purpose vehicle (SPV)?
- A legal entity set up to isolate certain assets and risks from its sponsor - correct
- A clearing house that stands between buyers and sellers of derivativesWhy not: Describes a CCP, not an SPV.
- A deposit-taking bank backed by a government guaranteeWhy not: Describes a regulated bank; an SPV typically has no deposits or guarantee.
- A branch of a dealer that guarantees all the dealer's derivative obligationsWhy not: An SPV is separate from the sponsor, not a guaranteeing branch.
SPVs are legally separate, often bankruptcy-remote entities used to hold assets or take risk apart from a sponsor. DPCs, monolines and CDPCs are related structures.
A harder one
Why would a client trade derivatives with a derivatives product company (DPC) instead of its dealer parent?
- The parent fully guarantees the DPC's obligations, so the DPC has the same credit quality as its parentWhy not: A DPC's strength comes from its separate capital and structure; a full parent guarantee would not improve on the parent.
- The DPC is a CCP with a mutualised default fund among all dealersWhy not: A DPC has capital from one sponsor and does not mutualise losses among dealers.
- It is separately capitalised, ring-fenced and highly rated, so it is stronger than the parent - correct
- The DPC takes unhedged positions, so it has no market risk and needs no capitalWhy not: DPCs hedge their positions back to their parents and still hold capital against residual risk.
A DPC lets clients deal with a highly rated, ring-fenced entity even when the parent is rated lower, with the DPC hedging its risk with the parent.
The hardest tier
A CDPC has USD 400 million of capital and has sold protection on USD 10 billion of notional. A credit crisis causes losses of 7 percent of the notional, and all protection buyers share losses equally. The share of claims the buyers recover from the CDPC is closest to:
- 100 percentWhy not: Assumes the high rating guarantees full payment, ignoring that capital limits payment.
- 57 percent - correct
- 4 percentWhy not: Reports capital as a share of notional rather than as a share of the claims due.
- 43 percentWhy not: Reports the unpaid shortfall of 300 of 700 instead of the amount recovered.
Claims = 7% x 10,000 = 700 million; capital = 400 million. Recovery = 400 / 700 = 57 percent. Leverage of 25 times makes such vehicles fragile in a crisis.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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