FRM Part II · FRM Exam Part II · Credit Derivatives
A protection buyer holds a CDS with notional USD 10 million on a reference entity that defaults. The cheapest-to-deliver bond trades at 40 percent of par after the credit event, and the contract is physically settled. Which describes the settlement?
With physical settlement the protection buyer delivers bonds with face value equal to the USD 10 million notional and receives USD 10 million in cash at par. The seller then holds the defaulted bonds worth 40 percent and bears the 60 percent loss. Cash settlement would pay USD 6 million.
- AThe seller pays USD 4 million and keeps the bond
- BThe buyer delivers bonds with USD 10 million face value and receives USD 10 million in cashCorrect
- CThe buyer delivers bonds with USD 4 million face value and receives USD 4 million in cash
- DThe seller pays USD 6 million in cash and the buyer keeps the bond
Explanation
Under physical settlement the buyer delivers bonds with face value equal to the notional (USD 10 million) and receives par, i.e. USD 10 million. The buyer's net loss recovery is thus par, with the seller bearing the 60 percent loss. Cash settlement would instead pay (1 - 0.40) x 10 = USD 6 million with the buyer keeping the bond.
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