Explanation:
CDS contracts are only as good as the ability of the seller of the insurance to pay in the event of loss. There are no guarantees on either the seller or purchaser sides of the contract. Unfortunately, as with all insurance contracts, there is a moral hazard component. Since the risk of repayment is transferred to the CDS seller, there may be a slight temptation for the underlying issuer to take more, not less, risk.
(Book 1, Module 4.1, LO 4.a)
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Question 41
The CEO of Credit Consultants has been asked to participate in a panel session at a local industry conference. During the Q&A component of the session, he was asked the following: "Why is it that CDS contracts may not fully protect the purchaser from loss, as is the case with a regular insurance contract, such as automobile insurance?" Which of the following is the best recommended response?
A
If one treats a CDS contract similarly to an insurance contract, the coverage of loss is only as good as the ability of the seller of the insurance to meet the contractual arrangements.
B
If one treats a CDS contract similarly to an insurance contract, the coverage of loss is only as good as the ability of the buyer of the insurance to meet the contractual arrangements.
C
CDS purchasers are guaranteed to receive coverage in the event of loss, so the question does not apply.
D
CDS contracts are built on the assumption that the underlying issuer will reduce operating risks to ensure the CDS contractual arrangements are covered.
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