Question

QUESTION 16

1. Which credit derivative has proven to be most successful one?

	a.	Credit-default swap.
	b.	Credit spread option.
	c.	Credit-linked note.

Answer 1

Answer. A. Credit default swap.

The credit default swap is most popular type of credit derivative. Its primary purpose is to hedge the credit exposure to a particular asset or issuer.

Credit default swaps are used to shift credit exposure to a credit protection seller.

Their primary purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default swaps operate much like a standby letter of credit or insurance policy. In a credit default swap, the protection buyer pays a fee to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit event by the reference obligation or the reference entity.

If a credit event occurs, then the protection seller must make a payment.

Because an option by definition involves a right and not an obligation to do something conditional upon an event occurring, the credit default swap involves an option-type payoff.

payoff is made when the credit event occurs in which case the protection buyer settles with the protection seller and receives the designated payment.