Question #7
Reading: Reading 29 Credit Default Swaps
PDF File: Reading 29 Credit Default Swaps.pdf
Page: 3
Status: Correct
Correct Answer: C
Question
It is most accurate to state that the upfront payment associated with a credit default swap (CDS) is:
Answer Choices:
A. greater when the reference obligation is high-yield debt rather than investment- grade debt
B. always zero due to the way CDS are priced at origination
C. sometimes made by the credit protection seller to the credit protection buyer. Peter Nathan an asset manager for a hedge fund and looking to include credit default swaps (CDS) in the portfolio. Nathan wants to know more about credit default swaps (CDS). He read a report that explained the characteristics of these products and the pricing theory. The report contained the following: Comment 1: In a CDS, the protection buyer is long the credit risk of the reference entity. Comment 2: In an index CDS, the lower the credit correlation, the cheaper the premium. Nathan owns some intermediate-term bonds issued by ABC Company and has become concerned about the risk of a near-term default, although he is not very concerned about a default in the long term. ABC Company's two-year duration CDS currently trades at 400 bps, and the five-year duration CDS is at 700 bps. Nathan evaluates the bonds of VAX and believes that some trading opportunities exist. The VAX bonds are currently trading at 260 bps above MRR in an asset swap, while the CDS premium is 200 bps
Explanation
The CDS upfront payment may either be from the protection buyer to the seller, or vice-
versa. If the credit spread is equal to the coupon rate, the upfront payment can be zero.
CDS are valued by calculating the difference between the present value of the protection
leg, versus the present value of the payment leg. The amount of upfront payment depends
on the difference between the credit spread on the reference obligation and the CDS
coupon rate, and hence need not be higher for a high-yield bond compared to an
investment grade bond.
(Module 29.2, LOS 29.c)
Peter Nathan an asset manager for a hedge fund and looking to include credit default swaps
(CDS) in the portfolio.
Nathan wants to know more about credit default swaps (CDS). He read a report that
explained the characteristics of these products and the pricing theory. The report contained
the following:
Comment 1:
In a CDS, the protection buyer is long the credit risk of the reference entity.
Comment 2:
In an index CDS, the lower the credit correlation, the cheaper the premium.
Nathan owns some intermediate-term bonds issued by ABC Company and has become
concerned about the risk of a near-term default, although he is not very concerned about a
default in the long term. ABC Company's two-year duration CDS currently trades at 400 bps,
and the five-year duration CDS is at 700 bps.
Nathan evaluates the bonds of VAX and believes that some trading opportunities exist. The
VAX bonds are currently trading at 260 bps above MRR in an asset swap, while the CDS
premium is 200 bps.