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Explanation:
First-to-Default Basket CDS is structured to specifically provide a payout upon the first default event within a basket of referenced entities, catering to the institution's need for targeted protection against the initial credit event observed among several assets.
A is incorrect. A Single-name CDS is designed to cover credit risk related to a single entity and would not provide a collective coverage across multiple assets as required by the financial institution.
B is incorrect. A Total Return Swap exchanges the total returns of an asset, including market and credit risk, for another set of cash flows, and is not tailored to provide payouts conditioned on the first default of a basket of assets.
C is incorrect. Synthetic CDOs distribute credit exposure and losses through a tranche structure; they offer investment in credit risk but are not designed to protect specifically against the first default event among multiple assets within their structure.
Things to Remember
Q.6062 A financial institution seeking to diversify its credit risk management strategy wishes to hedge against the potential default of several corporate bonds in its portfolio. They are in search of a credit derivative that specifically provides a payout upon the first default event among the covered assets, rather than covering each asset individually. Which credit derivative is explicitly designed to serve this purpose, protecting against the first credit event among multiple references?
A
Single-name Credit Default Swap (CDS).
B
Total Return Swap (TRS).
C
Synthetic Collateralized Debt Obligation (CDO).
D
First-to-Default Basket CDS.
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