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Answer: Credit derivatives can facilitate the transfer of credit risk without incurring significant funding liquidity risk.
## Explanation **A is correct.** Credit derivatives (e.g., CDS) were formulated precisely to enable this fine tuning. Credit derivatives are off-balance sheet instruments that facilitate the transfer of credit risk between two counterparties (the beneficiary who sells the risk and the guarantor who buys the risk) without having to sell the given position. Credit derivatives permit the isolation of credit risk (e.g., in a loan or a bond) and transfer that risk without incurring any funding or client management issues. **B is incorrect.** Securitization involves the repackaging of loans and other assets into new securities that then can be sold in the securities markets. Banks, for example, have used securitization to remove mortgage loans, corporate bank loans, credit card receivables, and automobile loans from their balance sheets. The securitization of these assets resulted in the creation of mortgage-backed securities, collateralized loan obligations, credit card-backed securities, and automobile-backed securities, respectively. The latter two securitized products are referred to as asset-backed securities (ABS). **C is incorrect.** Section 15G of the SEC Act of 2014 imposed risk retention provisions on asset-backed securities, including collateralized loan obligations (CLOs), of at least 5% of the credit risk. The Securities and Exchange Commission, in conjunction with U.S. federal banking regulators, finalized Section 15G of the Securities and Exchange Act in 2014. This imposed risk retention provisions on asset-backed securities, including CLOs. Specifically, the rules require securitizers to retain, without recourse to risk transfer or mitigation, at least 5% of the credit risk. **D is incorrect.** When properly executed in a robust, liquid, and transparent market, credit derivatives contribute to the process of credit price discovery (i.e., they clarify and quantify the market value for a given type of credit risk). In addition to quantifying the default risk incurred by many large corporations, CDS prices also offer a means to monitor default risks in real time (as opposed to credit rating assessments, which are periodic). The hope is that improvements in price discovery will eventually lead to enhanced liquidity, along with a more efficient market pricing of credit spreads for the full spectrum of instruments with credit risk exposure.
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A credit manager at a US-based bank is preparing a presentation to a group of interns on the role of credit derivatives in the 2007-2009 financial crisis and on subsequent changes in the credit derivative markets. The manager describes some characteristics of credit derivatives and also discusses some regulatory changes unique to the credit derivative markets. Which of the following statements is correct regarding credit derivatives?
A
Credit derivatives can facilitate the transfer of credit risk without incurring significant funding liquidity risk.
B
Securitization is used primarily for repackaging corporate bank loans and is limited in its use for collateralized loan obligations.
C
The required retention of credit risk for originators of asset-backed portfolios was increased from 10% to 25% by the US Securities and Exchange Commission after the crisis.
D
Credit derivatives markets are effective in measuring default risk over longer time horizons but are ineffective in measuring default risk in real time.