CFA Instittute CDS 2005 Q&A

Managing Portfolio Risk with Credit Derivatives Marc P. Seidner, CFA Director, Active Core Strategies Standish Mellon Asset Management Boston Question: During a major credit event, it seems more than possible that a CDS counterparty might be deteriorating in credit or ability to pay. Does this make buying CDS protection less desirable? Seidner: The question gets to the issue of systematic failure. We’ve survived the end of the world a couple of times in the financial markets, and we’re still here. It is a good question, but the issue hasn’t been tested, so it is difficult to say. I cannot think of an instance where a counterparty did not perform, although there have been many instances when the definition of the default event has been challenged. The best protection is to know the counterparty’s quality and ability to pay beforehand. In the event of a systematic failure, it is possible that the counterparty won’t be able to pay, but then again, maybe the counterparty will pay. Having the CDS protection is certainly better than nothing.