Fixed Income - Credit Default Swaps

Question 1

Underlying of CDS

Answer 1

borrower’s credit quality

Question 2

If you are long on the CDS

Answer 2

You’re the seller of CDS and you’re betting that on the improvement of credit quality

Question 3

If you’re short on the CDS

Answer 3

You’re the buyer of CDS and you’re betting on deteriorating credit quality

Question 4

CDS provides protection

Answer 4

against default but also protects against changes in credit quality long before a default

Question 5

The value of CDS

Answer 5

increases/decreases w/the changing likelihood of default

Question 6

Seller of CDS doesn’t have to pay until

Answer 6

default occurs

Question 7

CDS entails

Answer 7

the credit protection buyer makes a series of pyaments (premiums) to the credit protection seller and receives a promise of compensation for credit losses resulting from default (pre-defined credit event) of a 3rd party

Question 8

Single-name CDS

Answer 8

• a CDS on a specific borrower
• contract specifies a reference obligation (usu. senior unsecured debt)
• any other debt of equal priority of claims or higher relative to the reference obligation is covered
• Payoff of a CDS is determined by the cheapest to deliver obligation (same seniority as reference obligation)

Question 9

Index CDS

Answer 9

• a combination of borrowers
• introduces ‘credit correlation’ -> defaults by certain companies may be connected to defaults by other companies
• the more correlated the defaults, the more costly it is to purchase protection

Question 10

ISDA specifications

Answer 10

• each contract specifies a notional amount

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