Explanation:
This scenario describes Wrong-Way Risk (specifically, counterparty credit risk with wrong-way correlation). The investor bought a CDS from Issuer B (the protection seller) to protect against the default of Issuer A (the reference entity).
If the correlation between Issuer A and Issuer B increases, it means that if Issuer A defaults, there is a higher probability that Issuer B will also default simultaneously (joint default). If Issuer B defaults at the same time as Issuer A, Issuer B will be unable to fulfill its obligation to pay the protection amount to the investor. Because the reliability of the protection decreases, the value (price) of the CDS to the protection buyer decreases.
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Q.2 Assume that an investor has bought $2 million in a bond from Issuer A. They are now worried about Issuer A defaulting and have purchased a Credit Default Swap (CDS) from Issuer B. The value of the CDS is mainly determined by the default probability of the reference entity Issuer A. If the correlation between issuer A and B increases, what will be the impact on the price of the CDS?
A
The price of the CDS will decrease because there is a greater chance of joint default.
B
The price of the CDS will increase because there is a greater chance of joint default.
C
There will be no impact on the price of the CDS because it is working as a separate entity.
D
It may increase or decrease depending on the market and economic conditions of the country.