Explanation:
The buyer of a CDS faces wrong-way risk if the correlation between the reference entity (Issuer A) and the protection seller (Issuer B) increases. If both entities default at the same time (joint default), the CDS becomes worthless because the protection seller cannot fulfill its obligation exactly when the reference entity defaults. Therefore, an increase in correlation between the reference entity and the protection seller decreases the value (price) of the CDS from the protection buyer's perspective.
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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.
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