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FRM Part II · FRM Exam Part II · Derivatives

A fund buys protection on a reference bond through a CDS with physical settlement. A credit event occurs, and the bond trades at 35% of par. The CDS notional is USD 10 million. The fund holds no bonds. Which describes the settlement outcome?

The fund buys deliverable bonds at 35% of par for about USD 3.5 million, delivers them, and receives USD 10 million, netting about USD 6.5 million. This equals the cash-settlement payoff of par minus recovery.

  1. AThe fund delivers any deliverable obligation purchased at about USD 3.5 million and receives USD 10 million, for net gain of about USD 6.5 millionCorrect
  2. BThe fund receives USD 3.5 million with no delivery
  3. CThe fund pays USD 6.5 million to the seller and receives the bond
  4. DThe fund receives USD 10 million and keeps the bond

Explanation

In physical settlement the buyer delivers deliverable obligations with face value equal to notional and gets par. Buying bonds at 35% costs USD 3.5 million, so the net payoff is 10 − 3.5 = USD 6.5 million, equal to the cash settlement of par less recovery. Option D is wrong because the bond is delivered.

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