Financial Risk Manager Part 1
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Which of the following statements best describes credit default swaps (CDS)?
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TTanishq
A
Present high levels of risk and should only be used by the wealthy.
B
Allow a lender to transfer the credit risk of a borrower defaulting to another party.
C
Should only be used by people seeking high returns from low risk.
D
Do not require collateral to be posted by either the buyer or the seller of the insurance.
Explanation:
Explanation
Credit default swaps (CDS) are credit derivative contracts that function as insurance against credit risk. Here's why option B is correct:
- CDS Mechanism: The buyer of protection (typically a lender) makes periodic premium payments to the seller of protection
- Risk Transfer: If a specified credit event occurs (such as default, bankruptcy, or restructuring), the protection seller compensates the buyer
- Risk Management: This allows lenders to transfer credit risk to other parties willing to bear it
Why other options are incorrect:
- Option A: CDS are not exclusively for wealthy investors and their risk level depends on proper usage and counterparty risk management
- Option C: CDS are primarily risk management tools, not just return-seeking instruments, and they carry significant counterparty and legal risks
- Option D: Collateral arrangements are common in CDS contracts to mitigate counterparty credit risk, especially after the 2008 financial crisis reforms
CDS are important financial instruments in modern risk management, allowing institutions to hedge credit exposures and transfer risk efficiently.
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