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FRM Part II · FRM Exam Part II · Credit Derivatives

A dealer trades a CDS in which the protection seller pays only if the reference entity defaults. Which statement best describes the cheapest-to-deliver option in a physically settled CDS?

In a physically settled CDS the protection buyer chooses which eligible obligation to deliver and will typically pick the one with the lowest market price, since par is received regardless. This cheapest-to-deliver option has value to the buyer and is a cost to the protection seller.

  1. AThe seller chooses which bonds the buyer must deliver
  2. BThe buyer can choose among eligible deliverable obligations, and will normally deliver the one with the lowest market priceCorrect
  3. CThe buyer must deliver the bond with the highest coupon
  4. DThe option lets the buyer cancel the CDS after default

Explanation

Because payout is par for the delivered bond, the buyer benefits by delivering the eligible obligation with the lowest post-default price. This option has value and is borne by the protection seller. The seller does not choose the bond.

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