Handbook of Credit Risk Management, Ch 20: Credit Derivatives

Question 1

State the two standard credit events that apply to most CDS contracts

Answer 1

CDS payment is triggered by credit events

Standard credit events that apply to most contracts include:
1. Bankruptcy
2. Failure to pay

Question 2

Describe physical settlement of CDS contracts and state two disadvantages.

Answer 2

Once a credit event occurs, physical settlement of a CDS contract involves the
following:
Ÿ Protection buyer delivers the bond/loan to the protection seller
Ÿ Protection seller pays the protection buyer the underlying par value

Two disadvantages of physical CDS settlement:
1. Bond squeeze effect
Ÿ Protection buyers not holding the bond will need to buy it when a credit event occurs,
causing inflated prices and decreased profit for protection buyers
2. Other technical difficulties (e.g. need to deliver the bond of the appropriate
contractual terms including the appropriate tenor)

Question 3

State the payment from the CDS seller to the CDS buyer upon a credit event if cash
settlement is used.

Answer 3

(1 - Recovery Rate) CDS Notional

Question 4

State the three predominant uses of CDS

Answer 4

1. Protection of a Credit Exposure ñ Buy CDS and Bond
2. Investment in Credit: Long Credit ñ Short CDS
3. Speculation In Credit: Shorting Credit ñ Buy CDS

Question 5

State the two disadvantages of using CDS to hedge bond credit risk

Answer 5

Disadvantages include (1) income statement volatility and (2) basis risk

Basis risk captures the difference between the actual loss and the compensation
received from the settlement

Question 6

State the two advantages of selling naked CDS.

Answer 6

1. Allows one to take credit risk on a stand-alone basis (e.g. can just sell a CDS
   without holding a bond and carrying large interest rate risk)
2. Selling a CDS does not require a cash investment
   Ÿ However, there may be collateral requirements
   Ÿ CDS positions are leveraged, and protection buyers want to ensure that protection
   sellers have adequate liquidity if a credit event occurs
   Note that naked simply means there is no bond position held.

Question 7

Describe the three steps for buying naked CDS.

Answer 7

Three steps involved for implementing short credit trades:
1. Fund manager identifies a reference entity where they believe financial conditions
will deteriorate more aggressively than the overall market anticipates
2. Buy CDS, often from multiple counterparties in order to reach a large notional
3. After the significant credit deterioration occurs, the fund manager can either
unwind or sell the position for a profit