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Answer: The firm would pay a periodic fixed fee and in turn receive a contingent payment in the event of credit default.
## 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.
Author: Tanishq Prabhu
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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:
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.