Financial Risk Manager Part 1

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.