Financial Risk Manager Part 1

Explanation

This question tests understanding of credit default swaps (CDS) as credit risk management tools.

Correct Answer: A

A credit default swap (CDS) is a financial derivative that functions like insurance against credit events such as defaults. In this scenario:

• The investment firm is the protection buyer
• The firm pays periodic fixed fees (premiums) to the protection seller
• In return, the firm receives contingent payments if a credit event occurs (such as default on the CDOs)

This structure allows the firm to hedge its credit risk exposure from the CDO investments.

Why Other Options Are Incorrect:

B: Incorrect because:

• CDS does not provide 100% protection (counterparty risk exists)
• Cash inflows from CDOs are never guaranteed regardless of CDS protection

C: Incorrect because CDS contracts typically involve periodic premium payments, not a single upfront fee.

D: Incorrect because contingent payments are triggered by credit events, not automatically at the end of CDO contracts.