CAIA practice exam Q 2

  1. Which of the following statements MOST accurately identifies a major benefit offered by credit default swaps (CDS)? A. CDS allow for separation of default and interest rate risks B. CDS greatly improve public risk transparency C. CDS offer protection against market overreaction to news releases D. CDS eliminate credit market counter-party risk The answer is A. I thought counter-party risk could be eliminated via a CDS? Can anyone explain?

no, counter-party risk cannot be eliminated via a CDS. Actually, by entering into a CDS contract, the protection buyer eliminates the default risk and assumes the counter-party risk. the risk that the protection seller does not fulfill its obligations

IMHO, the CDS buyer assumes counterparty risk by entering into a contract with the CDS seller (i.e., the CDS seller may not fulfill his obligation in case of default), however, the counterparty risk of the underlying (i.e., mortgage buyers defaulting = default risk = credit risk)) would be hedged successfully, which is why he entered the CDS in the first place. Is this approach flawed?

Also, I think default and interest rate risk are examples of credit risk, which would restate A as “[…] allow for the isolation of credit risk.”

The underlying is not necessarily a counter-party, nor is it’s default risk necessarily eliminated by entering into the CDS (could be risk-mitigated, could be a naked bet, etc.).

I agree, but why exactly is D (CDS eliminate credit market counterparty risk) incorrect now?

b/c A is the best answer. It’s air tight and D has problems b/c it can be true but not always true.

Thx Nep-hi, that is fair enough and makes perfect sense in a CAIA world :wink: I was not sure whether D was never true or only sometimes.