Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

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What is most accurate regarding the buyer of a credit-linked note (CLN)?

Selling protection on the reference asset and receives a lower coupon payment compared to a straight bond.
Buying protection on the reference asset and receives a lower coupon payment compared to a straight bond.
Selling protection on the reference asset and receives a higher coupon payment compared to a straight bond.
Buying protection on the reference asset and receives a higher coupon payment compared to a straight bond.

The correct answer is: Selling protection on the reference asset and receives a higher coupon payment compared to a straight bond.

A credit-linked note (CLN) is an instrument that allows investors to gain exposure to the credit risk of a reference asset, typically a bond or loan, without actually holding the underlying asset. Buyers of CLNs generally do not receive higher coupon payments in exchange for taking on credit risk. Instead, they often receive lower coupon payments compared to traditional bonds because they are essentially paying for the insurance against default risk by the issuer of the reference asset. The accurate characterization of the buyer of a CLN focuses on the nature of the investment. By purchasing a CLN, they assume the credit risk associated with a specific reference asset while receiving a return that reflects that risk, typically lower than what a straightforward bond would provide, as the additional return compensates for the extra risk taken. Therefore, option C incorrectly suggests that the buyer would receive a higher coupon payment, which is not aligned with the fundamental mechanics of CLNs. In summary, buyers of credit-linked notes accept the credit risk and receive lower yields because of this risk exposure, making the statement about selling protection while receiving a higher coupon more accurate. The nature of a CLN significantly involves assumptions around credit risk and compensation, which is vital for understanding how these financial instruments function.