A RISK MANAGER IS ADVISING THE TRADING DESK ABOUT ENTERING INTO A...

12.

A risk manager is advising the trading desk about entering into a digital credit default swap as a way to

obtain credit protection. Which cash flow and delivery requirement will the desk most likely experience in the

event of a default of the underlying reference asset?

a.

Receive the pre-agreed cash payment; deliver nothing.

b.

Receive [(Par Value) - (Market Value of Reference Asset)]; deliver the reference asset.

c.

Receive [(Par Value) - (Market Value of Reference Asset)]; deliver nothing.

d.

Receive the pre-agreed cash payment; deliver the reference asset.

Correct Answer: a

Rationale:

A digital CDS will pay off a pre-determined fixed amount in the event of a default. Digital CDS are often

used against highly illiquid reference assets that would be difficult to price.

Section: Credit Risk Measurement and Management

Reference:

Christopher Culp (2006), Structured Finance and Insurance: The Art of Managing Capital and Risk, 1st

Edition, Chapter 12, “Credit Derivatives and Credit Linked Notes,” pp. 252-254.

Learning Objective:

Describe the mechanics and attributes of a single named credit default swap (CDS).