Explanation:
The reference obligation also referred to as the reference asset, is the particular debt issue for which the credit protection is being sought. In this case, that’s the 5-year bond.
Option A is incorrect: The reference entity is the issuer of the debt instrument and hence, also referred to as the reference issuer. In this case, for example, ABC Company is the reference entity.
Option C is incorrect: The insurer only makes a settlement if a credit event occurs, whenever that may be – provided it occurs within the term of the contract.
Option D is incorrect: Premium payment by the protection buyer is not contingent on a credit event.
Section: Foundations of Risk Management
Chapter: Credit Risk Transfer Mechanisms
Learning Objective: Compare different types of credit derivatives, explain their applications, and describe their advantages
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Q.92 Bank A buys a 5-year bond issued by ABC Company. In order to hedge the default of ABC Company, Bank A could buy a credit default swap (CDS) from insurance company X. The bank keeps paying fixed periodic payments (premiums) to the insurance company, in exchange for default protection. Which of the following is correct?
A
The reference entity is the 5-year bond.
B
The reference obligation is the 5-year bond.
C
Company X pays bank A the par value of the bond at maturity of the CDS contract.
D
Bank A pays premiums only if a credit event occurs.