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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank buys five-year protection on a corporate bond it holds, using a single-name credit default swap. Which statement best describes the bank's position in this CDS?

The bank, as protection buyer, pays a regular CDS premium and receives a compensating payment from the protection seller if a credit event occurs on the reference entity. The seller is the one who receives the premium and bears the default risk.

  1. AIt pays a periodic premium and receives a payment from the seller if a credit event occursCorrect
  2. BIt receives a periodic premium and pays the seller if a credit event occurs
  3. CIt pays the premium only if the reference entity defaults, in exchange for the bond's par value
  4. DIt receives the bond's coupons from the seller and pays the premium at maturity

Explanation

The protection buyer pays a periodic spread (premium) and receives a contingent payment from the protection seller if a credit event occurs on the reference entity. Option B reverses the roles of buyer and seller.

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