FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
Which statement about a CDS buyer who holds no underlying exposure to the reference entity (a naked position) is correct?
A naked protection buyer profits if the reference entity's credit spread widens. The buyer is effectively short credit, so existing protection at a lower fixed spread gains value as perceived default risk rises, even before any credit event occurs.
- AThe position profits if the reference entity's credit spread widensCorrect
- BThe position profits if the reference entity's credit spread narrows
- CThe position has a payoff identical to a long position in the reference bond
- DThe position has no market value change before a credit event
Explanation
A protection buyer is short credit risk: when spreads widen, the existing contract at the lower fixed spread becomes more valuable. A long bond position is the opposite exposure, and CDS value does change with spreads before any credit event.
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