I understand the concept of securitization. However, cannot follow one sentence in ASET notes April 2011 paper 2 Q 5 (ii). "this will result in any potential loss in value of the asset being capped". Could you please explain this? Thanks.
Let's think about an example where the underlying asset (e.g. present value of future profits on an insurance portfolio) has an expected value of 150. The insurance company may choose to securitise 100 of that value, in the form of a bond issued to investors. Bear in mind the key point that the bond is only repaid if sufficient profits arise. This generates the "transfer of risk" that the course notes also refer to. If the value of the profits which actually arise (i.e. the value of the asset that has been securitised) is between 0 and 50 less than expected (i.e. has fallen to between 100 and 150), the insurance company must still repay the loan in full (value of 100) and it suffers the relative loss in value itself. However, if the value of the asset falls by more than 50 (e.g. say it falls by 70 to a value of 80) then the insurance company only has to repay from the actual profits arising (i.e. in this case it would repay 80 rather than 100). So it has only effectively "lost" a value of 50 rather than the full 70 reduction in asset value. Hence the loss in value of asset is (broadly speaking) capped at 50 in this example. [In practice the operation is a little more complicated than this, but the broad underlying principle is that there is some transfer of risk relating to the value of the future profits, or whatever the securitised asset is, from the issuer of the securitisation to the investor.] Hope that helps. You might want to consider numerically how the value would effectively be split between the issuer and investor at different levels, and this could help to demonstrate the "cap".
