GMAT Practice Question Set #8 (Question 22-24)

GMAT Integrated Reasoning  >  Two-Part Analysis Question # 22: Credit Default Swap Dilemma  
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James: The price of credit defaults swaps (CDS) for ABC company is exploding to the upside. Credit default swaps are effectively insurance contracts on the possibility of a company defaulting on its loans. CDS prices have gone up, partly because ABC took out more loans than they can handle. These additional loans increase the risk of default and are passed on to CDS investors in the form of more expensived insurance premiums. Therefore, reducing the quantity of unnecessary loans will be effective in lowering the price of credit default swap contracts.

Alexis: In many cases, the unnecessary loans that you mention are decisions made by upper management on behalf of the company. CEO's will often choose the financing option that maximizes the debt to equity ratio and potential valuation of the company, but may not necessarily benefit the company. As a result, in order to succeed in reducing the price of credit default swaps, we should allow the company's board of direcctors to vote on which form of financing the company should allow and which forms it shoud not allow.

In the table below, identify the assumptions upon which each person's argument depends. Choose one option for each column.

James

Alexis

CEOs are generally able to pick out, with consistent reliability, which loans and financing options would be best for the company.

Additional loans do not account for an insignificant part of why investors have bid up the probability of the company defaulting on existing loans.

Credit default swap prices in other industries such as oil & gas and retail, have been lowered by reducing the number of additional loans taken out by the company.

Company shareholders are not as likely as CEOs to take out additional loans.

Credit default swap prices have increased three times as fast in the past 3 years than they have over the past decade.

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