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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

Which feature distinguishes physical settlement from cash settlement in a CDS following a credit event?

In physical settlement the protection buyer delivers defaulted bonds with face value equal to the notional to the seller and receives par in cash. In cash settlement no bonds change hands; the seller pays par minus the determined post-default market value.

  1. AIn physical settlement the buyer delivers defaulted bonds to the seller for par valueCorrect
  2. BIn physical settlement the seller pays only the difference between par and the market price
  3. CIn cash settlement the buyer must deliver the cheapest bond to the seller
  4. DIn cash settlement the premium stops but no payment is made

Explanation

Under physical settlement the protection buyer delivers deliverable obligations with face value equal to the notional and receives par. Cash settlement pays par minus the post-default market price (determined by auction), with no delivery.

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