Explanation

Let's analyze how each factor affects CDS value:

Option A: Recovery Rate - CORRECT

• An increase in recovery rate reduces the value of a CDS
• Higher recovery rate means lower loss given default (LGD = 1 - Recovery Rate)
• Lower LGD means the protection seller pays less in case of default
• Therefore, the CDS protection becomes less valuable

Option B: Expected Exposure - INCORRECT

• An increase in expected exposure would typically increase the value of a CDS
• Higher exposure means greater potential losses, making credit protection more valuable

Key Relationship:

• CDS Value ∝ Probability of Default × Loss Given Default
• Loss Given Default = 1 - Recovery Rate
• Therefore, as Recovery Rate increases, Loss Given Default decreases, reducing CDS value