Financial Risk Manager Part 1
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Two parties decide to engage in a 2-year credit default swap. Assume that the reference entity is BAC Corporation. The notional amount of the contract is $10 million, and the contract is cash-settled. After one year, a default event occurs, and the bonds are valued at $8.5 million at the time of default. Which of the following is most likely correct?
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A
The protection buyer receives $1.5 million in compensation.
B
The protection buyer continues to pay premiums for one more year.
C
The protection buyer delivers the bond to the protection seller.
D
There is no compensation paid to the protection buyer.
Explanation:
In a credit default swap (CDS), the protection seller compensates the protection buyer in the event of a default. The compensation amount is typically the difference between the notional amount of the contract and the market value of the defaulted bond. In this case, the notional amount is $10 million and the market value of the bond at the time of default is $8.5 million. Therefore, the protection buyer receives $1.5 million in compensation. This is the fundamental principle of a CDS - it provides insurance against the risk of default. The protection buyer pays a premium to the protection seller for this insurance, and in return, the protection seller agrees to compensate the protection buyer if a specified credit event, such as a default, occurs.
Choice B is incorrect. The protection buyer does not continue to pay premiums for one more year. In a credit default swap agreement, once a default event occurs, the contract is terminated and no further premiums are required to be paid by the protection buyer.
Choice C is incorrect. The protection buyer does not deliver the bond to the protection seller in this scenario as it's a cash-settled contract. In cash settlement, the difference between par value and market value of defaulted bond (recovery rate) is paid by the seller to the buyer; there's no physical delivery of bonds.
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