FINA 475 - Fixed Income Securities - Sample Questions - Credit Default Swaps

Vocabulary flashcards related to credit default swaps (CDS) concepts.

Credit Default Swap (CDS)

A derivative instrument that provides protection against the risk of a bond issuer defaulting on its payments.

Why a hedge fund would buy CDS protection

To hedge its exposure against potential default.

The most significant risk the bank faces in this transaction

The reference entity defaulting and having to make a large payout.

What happens to the value of an existing CDS contract that references that company if a company’s credit rating is downgraded

The perceived default risk rises, increasing the value of existing CDS protection.

Typical reason for a hedge fund to buy CDS protection

CDSs are primarily focused on credit risk of bonds or loans; they typically do not address counterparty risk in an equity swap.

Effect on an existing CDS position if credit spreads of a company widen significantly

Reflect greater perceived default risk, increasing the market value of CDS protection for the buyer.

Difference between physical and cash settlement in a credit default swap

In physical settlement, the protection buyer delivers eligible bonds or loans to the seller in exchange for par value; in cash settlement, the protection buyer simply receives a payment reflecting the price difference from par.

Cheapest-to-deliver

The protection buyer’s ability to deliver any eligible debt obligation, often selecting the one trading at the lowest price.