Financial Risk Manager Part 1

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:

• 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.

• 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.

• 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.