Financial Risk Manager Part 1

In a credit default swap (CDS) transaction, the protection buyer indeed makes periodic payments. This is a fundamental aspect of a CDS transaction. The protection buyer, who is seeking to hedge against the risk of a third party defaulting on its obligations, makes these payments to the protection seller. In return, the protection seller promises to compensate the protection buyer if the third party defaults. This arrangement allows the protection buyer to transfer the credit risk associated with the third party to the protection seller. The periodic payments made by the protection buyer are often referred to as 'premiums' or 'spreads' and are typically calculated as a percentage of the notional amount of the CDS contract.

Choice A is incorrect. The protection buyer in a CDS transaction is actually short on risk, not long. This is because the protection buyer pays a premium to the protection seller to take on the credit risk of a reference entity. If that entity defaults, the protection seller compensates the buyer, thus reducing their exposure to risk.

Choice B is incorrect. Contrary to this statement, the protection seller in a CDS transaction is long on risk. They receive regular payments from the protection buyer and in return agree to cover losses if a specified credit event occurs with respect to an underlying reference entity.

Choice C is incorrect. In fact, it's just opposite of what happens in reality; it's not the protection seller but rather it's actually the Protection Buyer who makes periodic payments (premiums) as part of their agreement with Protection Seller.