Module: | MODULE B: RISK MANAGEMENT
Q400: Scenario: A commercial bank holds high-yield corporate bonds issued by ABC Corporation and purchases a Credit Default Swap to hedge the exposure. Months later, ABC Corporation faces a severe liquidity crisis, officially misses a scheduled coupon payment, restructures its outstanding debt to extend the maturity by 5 years, and eventually files for formal bankruptcy. Based on standard International Swaps and Derivatives Association definitions of a Credit Event under a Credit Default Swap, consider the following statements:
1. The officially missed coupon payment qualifies as a Failure to Pay credit event, triggering the Credit Default Swap contract.
2. A formal Restructuring that results in a material credit loss to the lender is universally recognized as a valid credit event.
3. Bankruptcy is strictly excluded from standard Credit Default Swap credit event triggers to prevent systemic contagion across derivative markets.
Which of the statements given above is/are correct?
2. A formal Restructuring that results in a material credit loss to the lender is universally recognized as a valid credit event.
3. Bankruptcy is strictly excluded from standard Credit Default Swap credit event triggers to prevent systemic contagion across derivative markets.
Which of the statements given above is/are correct?
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: Failure to Pay is one of the most common and standard Credit Events under the International Swaps and Derivatives Association (ISDA) framework.
A missed coupon or principal payment triggers the CDS payout mechanism.
Statement 2 is correct: Restructuring is a valid Credit Event.
If a distressed company forces lenders to accept altered terms (like reduced interest rates or extended maturities) that result in a negative economic impact on the lender, the CDS protection seller is obligated to cover that loss.
Statement 3 is incorrect: Bankruptcy is the ultimate and most definitive Credit Event in a CDS contract.
It is absolutely never excluded; protecting against a formal bankruptcy filing is the fundamental purpose of inventing the Credit Default Swap.
A missed coupon or principal payment triggers the CDS payout mechanism.
Statement 2 is correct: Restructuring is a valid Credit Event.
If a distressed company forces lenders to accept altered terms (like reduced interest rates or extended maturities) that result in a negative economic impact on the lender, the CDS protection seller is obligated to cover that loss.
Statement 3 is incorrect: Bankruptcy is the ultimate and most definitive Credit Event in a CDS contract.
It is absolutely never excluded; protecting against a formal bankruptcy filing is the fundamental purpose of inventing the Credit Default Swap.