Financial Risk Manager Part 1
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Credit default swaps (CDS) are financial derivatives used to hedge or speculate on the credit risk of a borrower. Understanding the contractual specifications for the protection seller is crucial for evaluating the obligations and benefits involved in these transactions. What are the contractual specifications for the protection seller of a credit default swap?
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A
The protection buyer pays a premium to the protection seller at regular time intervals until a credit event occurs, in which case the protection seller pays the protection buyer compensation for the credit event.
B
If a credit event occurs, the protection seller is obligated to exchange contractually specified assets for government bonds.
C
The protection seller pays a premium to the protection buyer at regular time intervals until a credit event occurs, in which case the protection buyer pays the protection seller compensation for the credit event.
D
If the underlying of the credit default swap is a bond issued by a specific corporation, only this corporation can act as a protection seller.
Explanation:
Explanation
In a credit default swap (CDS), the protection seller is essentially selling insurance against the default risk of a specific credit instrument, such as a bond or loan. The protection buyer pays a premium to the protection seller at regular intervals. This premium is essentially the cost of the insurance. If a credit event, such as a default, occurs, the protection seller is obligated to compensate the protection buyer. The compensation is usually the face value of the credit instrument. This arrangement allows the protection buyer to hedge against the risk of default. The protection seller, on the other hand, earns a premium for taking on this risk.
Why other options are incorrect:
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Choice B is incorrect because in a credit default swap, the protection seller does not exchange assets for government bonds in the event of a credit event. Instead, they are obligated to compensate the protection buyer for their loss.
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Choice C is incorrect because this choice incorrectly reverses the roles of the protection buyer and seller. In reality, it's the protection buyer who pays premiums to the seller until a credit event occurs, at which point it's then up to the seller to compensate them.
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Choice D is incorrect because the underlying asset of a CDS can be any kind of debt instrument - not just corporate bonds - and any party (not just corporations) can act as a protection seller as long as they are willing and able to fulfill their obligations under contract terms.
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