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).