Financial Risk Manager Part 1
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Q.414 In 2005, a certain American investment firm decided to invest in an assortment of collateralized debt obligations (CDOs). To protect itself, the firm also purchased a credit default swap. This implied that:
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A
The firm would pay a periodic fixed fee and in turn receive a contingent payment in the event of credit default.
B
The firm was 100% protected against credit default, and therefore cash inflows from the CDOs were guaranteed.
C
The firm would pay a fixed fee at the onset of the contract and in turn receive a contingent payment in the event of credit default.
D
The firm would pay a periodic fixed fee and, in turn, receive a contingent payment at the end of the CDO contract.
Explanation:
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.
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