FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
A protection buyer holds a CDS on Firm Q with notional $10 million. A credit event occurs and the contract is cash settled using an auction. The auction determines the reference obligation's final price at 35% of par. What is the payout from the protection seller to the buyer?
The seller pays $6.5 million. In cash settlement the payout equals notional times one minus the auction recovery price, so $10 million times 65% gives $6.5 million. The $3.5 million represents the recovered value of the bond, not the CDS payment.
- A$6.5 millionCorrect
- B$3.5 million
- C$10.0 million
- D$0.65 million
Explanation
Payout = notional × (1 − recovery price) = $10 million × (1 − 0.35) = $6.5 million. The $3.5 million figure is the recovery value itself, which the buyer keeps through holding the bond, not the payout.
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