FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
An investor wants to take a view that the credit quality of Firm M will deteriorate, but holds none of Firm M's bonds. Which action using CDS achieves this view most directly?
The investor should buy CDS protection on Firm M. The position gains when Firm M's credit spreads widen or it defaults, giving a bearish credit view without owning its bonds. Selling protection would profit from improvement instead, the opposite view.
- ABuy CDS protection on Firm M (a naked position)Correct
- BSell CDS protection on Firm M
- CBuy Firm M bonds and sell CDS protection on them
- DSell Firm M bonds short and sell CDS protection
Explanation
Buying protection gains value as Firm M's spread widens or default occurs, even without owning the bond. Selling protection profits if credit improves, so it is the opposite view. Other combinations add or neutralize exposure inconsistently with a bearish view.
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