CFA Level I · CFA Level I Exam · Forward Commitment and Contingent Claim Features and Instruments
An investor holds a corporate bond and buys five-year CDS protection on the same issuer. Compared with holding the bond alone, the investor's position is most likely to have:
The investor has reduced default risk on the issuer but still bears the risk that the protection seller fails to pay. The hedge is not perfect, so credit risk is not entirely eliminated, and exposure to spread widening is lower, not greater, than holding the bond alone.
- Agreater exposure to a widening of the issuer's credit spread
- Breduced default risk but retained exposure to the counterparty's ability to payCorrect
- Celiminated all credit risk because the CDS fully offsets the bond's cash flows
Explanation
Buying protection transfers the issuer's default loss to the seller, but the investor now faces counterparty risk that the seller cannot perform. The hedge is not perfect because of basis, maturity and settlement differences, so not all credit risk is removed, and exposure to spread widening is reduced, not increased.
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