FRM Part II · FRM Exam Part II · Credit Derivatives
A CDS on a corporate bond is physically settled after a credit event. Which describes the settlement correctly?
Under physical settlement, the protection buyer delivers a deliverable obligation of the defaulted reference entity to the seller and receives the full notional (par) in return. The buyer is thus compensated for the loss regardless of the bond's market value after default.
- AThe protection buyer delivers an eligible reference obligation and receives its par value from the sellerCorrect
- BThe protection seller delivers the defaulted bond and receives par from the buyer
- CThe protection buyer receives notional minus the recovery rate in cash, with no delivery of any bond
- DThe protection seller pays only the accrued premium and the contract terminates
Explanation
In physical settlement the buyer delivers the defaulted deliverable obligation and the seller pays par (notional). Option C describes cash settlement. Option B reverses the direction of delivery.
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