Credit Risk Management Practice Exam

What does a credit derivative pay off contingent on?

1. A specified interest rate

2. A specified credit event

3. The firm's operational performance

4. The maturity of the issuer

The correct answer is: A specified credit event

A credit derivative is a financial instrument whose value is derived from the credit risk of a reference entity. The payoff of a credit derivative is contingent upon a specified credit event occurring. Common credit events include defaults, bankruptcies, or restructuring of the reference entity's debt. When these events occur, the credit derivative triggers a payment to the holder, which can help mitigate losses resulting from the underlying credit risk. This makes credit derivatives a crucial tool for risk management in finance, allowing investors to hedge against potential defaults or credit declines without having to own the underlying asset directly. The other options do not accurately reflect the nature of credit derivatives. Interest rates, operational performance, and the maturity of the issuer are factors relevant to other financial instruments but do not determine the payoff structure of a credit derivative. Thus, the correctness of identifying a specified credit event as the contingent factor reflects an understanding of the fundamental role credit derivatives play in managing credit risk.