Questions about Skew Notes
Please read the feature articles from Risk Magazine and the other background articles postedon the Canvas site. Prepare a brief report to address the questions below.
� Question 1. What is the CDX “skew”? How exactly is it calculated? What arbitragetrade is available to market participants in, for example, December 2018? Who istaking the other side of this trade?
� Question 2. Suppose you work for a bank and want to take advantage of the opportu-nity to issue a skew bond. Assume the skew is -15 bp when the transaction is initiated.Design an arbitrage transaction that can pay investors SOFR + 200 bp with no riskto their principle. Explain the terms of the deal and what trades your bank needs toundertake to set up the note, and to guarantee that investor’s principle is protected.Show a diagram of where all the cash-flows go in your structure.
You may find it helpful to read the prospectus for the Libretto 2016 bonds issued byCitibank that is on the Canvas site.
� Question 3. Explain what happens in your transaction if, after the deal is sold, theskew gets more negative. Assume that positions in index CDS contracts and single-name CDS contracts are marked to market. Suppose that after issuance the skewmoves to -40 bp. Does any party (either your bank or the note holders) have to payadditional cash to anyone? How much? Will they get the money back? Explain.
� Question 4. Skew notes are an illustration of creative financial engineering: tappinga pool of capital that might only be able to earn negative interest rates on other safeinvestments, and creating a positive yield via exploiting an arbitrage relationship. Whydo you think banks and hedge funds are not doing this (i.e. taking advantage of thearbitrage opportunity) for themselves?
