Credit Risk Management Practice Exam

What type of payment is involved in a credit default swap (CDS)?

1. A fixed payment in exchange for equity

2. A fixed payment in exchange for debt payment

3. A variable payment based on market conditions

4. A one-time payment at maturity

The correct answer is: A fixed payment in exchange for debt payment

In a credit default swap (CDS), the involved payment is a fixed payment made by the protection buyer to the protection seller in exchange for the seller's commitment to compensate the buyer in the event of a credit event (such as default) occurring on a specified debt instrument. This mechanism allows the protection buyer to hedge against potential losses related to credit risk associated with a borrower or issuer of a bond. The fixed payment typically resembles an insurance premium that the buyer pays regularly, usually expressed as a percentage of the notional amount of the debt being insured. The protection seller, in turn, agrees to pay the buyer a predetermined amount should a default or other credit event occur, thus offering a safety net against credit risk exposure. This structure fundamentally distinguishes CDS from other financial instruments, as it does not involve an exchange of ownership or the equity of a company nor a variable payment that fluctuates based on market conditions. The clarity and predictability of fixed payments make CDS a popular tool for managing credit risk in financial markets.