LOS a: Describe the characteristics of a credit default swap, and compare and contrast a credit default swap to a corporate bond.

Q1. Which of the following most accurately describes the appropriate position in credit default swaps and bonds? If an investor believes that credit risk is overstated by the market, the investor should:

A)   sell a bond or sell a credit default swap.

B)   sell a bond or buy a credit default swap.

C)   buy a bond or sell a credit default swap.

Q2. A firm will potentially undergo a major financial restructuring where some of its debt may get downgraded. Which of the following positions would provide a bond investor protection against this event?

A)   The fixed side of a plain vanilla interest rate swap.

B)   The sale of a credit default swap.

C)   The purchase of a credit default swap.

Q3. Which of the following most accurately describes the behavior of credit default swaps?

A)   When credit and interest rate risk increases, swap premiums increase.

B)   When credit risk increases, swap premiums increase.

C)   When credit risk increases, swap premiums increase, but when interest rate risk increases, swap premiums decrease.

LOS a: Describe the characteristics of a credit default swap, and compare and contrast a credit default swap to a corporate bond. fficeffice" />

Q1. Which of the following most accurately describes the appropriate position in credit default swaps and bonds? If an investor believes that credit risk is overstated by the market, the investor should:

A)   sell a bond or sell a credit default swap.

B)   sell a bond or buy a credit default swap.

C)   buy a bond or sell a credit default swap.

Correct answer is C)

To gain an exposure to credit risk, an investor could buy a bond or sell a credit default swap. When the market realizes that a bond has less credit risk than thought, the bond will rise in price. Alternatively, by selling the swap, the investor would receive a premium up front and owe no further compensation to the swap buyer if in fact the bond does not experience a credit event.

Q2. A firm will potentially undergo a major financial restructuring where some of its debt may get downgraded. Which of the following positions would provide a bond investor protection against this event?

A)   The fixed side of a plain vanilla interest rate swap.

B)   The sale of a credit default swap.

C)   The purchase of a credit default swap.

Correct answer is C)

A credit default swap becomes more valuable when the reference obligation (e.g. a bond) decreases in credit quality. The credit events that trigger compensation from a credit default swap are usually defined as bankruptcy, entity default, and restructuring. The purchase of the swap provides the buyer compensation if a credit event occurs. Plain vanilla interest rate swaps protect against market-wide interest rate risk but not credit risk.

Q3. Which of the following most accurately describes the behavior of credit default swaps?

A)   When credit and interest rate risk increases, swap premiums increase.

B)   When credit risk increases, swap premiums increase.

C)   When credit risk increases, swap premiums increase, but when interest rate risk increases, swap premiums decrease.

Correct answer is B)

When credit risk increases, credit default swaps increase in value because the protection they provide is more valuable. Credit default swaps do not provide protection against interest rate risk however.

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