Module: | MODULE B: RISK MANAGEMENT
Q399: Consider the following statements regarding the structural mechanics of a Credit Default Swap:
1. The Protection Buyer makes continuous, periodic premium payments to the Protection Seller over the predefined life of the contract.
2. The Protection Seller is obligated to make a contingent financial payout to the buyer strictly upon the occurrence of a predefined Credit Event.
3. Entering into a Credit Default Swap contract strictly requires the Protection Buyer to hold the underlying reference asset on their balance sheet at all times.
Which of the statements given above is/are correct?
2. The Protection Seller is obligated to make a contingent financial payout to the buyer strictly upon the occurrence of a predefined Credit Event.
3. Entering into a Credit Default Swap contract strictly requires the Protection Buyer to hold the underlying reference asset on their balance sheet at all times.
Which of the statements given above is/are correct?
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: In a Credit Default Swap (CDS), the Protection Buyer effectively buys insurance against the default of a third party (the reference entity). To maintain this protection, the buyer must pay a regular, periodic fee (the CDS spread or premium) to the Protection Seller.
Statement 2 is correct: The Protection Seller collects these premiums and takes on the credit risk.
The seller only makes a large, contingent payout (either physical delivery or cash settlement) if a specific, legally predefined Credit Event occurs.
Statement 3 is incorrect: While retail users and hedgers must hold the underlying exposure, global financial markets heavily utilize Naked CDS transactions.
Market makers and institutional non-retail users are perfectly permitted to buy CDS protection for speculative or trading purposes without actually owning the underlying reference asset on their balance sheets.
Statement 2 is correct: The Protection Seller collects these premiums and takes on the credit risk.
The seller only makes a large, contingent payout (either physical delivery or cash settlement) if a specific, legally predefined Credit Event occurs.
Statement 3 is incorrect: While retail users and hedgers must hold the underlying exposure, global financial markets heavily utilize Naked CDS transactions.
Market makers and institutional non-retail users are perfectly permitted to buy CDS protection for speculative or trading purposes without actually owning the underlying reference asset on their balance sheets.