FRM Part II · FRM Exam Part II · Credit Derivatives
Under physical settlement of a single-name CDS after a credit event, which feature gives the protection buyer the cheapest-to-deliver option?
The buyer can deliver any eligible deliverable obligation and receives par, so it will deliver the lowest-priced bond. This cheapest-to-deliver option benefits the protection buyer and is priced into the CDS spread.
- AThe buyer may deliver any eligible deliverable obligation, so will choose the one with the lowest market priceCorrect
- BThe seller selects the bond to be delivered to minimize its payout
- CThe buyer must deliver the reference obligation named at inception
- DThe buyer receives the market value of the cheapest bond in cash
Explanation
In physical settlement the buyer delivers eligible obligations of the reference entity and receives par. Because all rank equally after default but trade at different prices, the buyer delivers the cheapest, which has value to the buyer. The seller does not choose.
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