Question

Assume that you are lending money to company X. A credit default swap (CDS) consists of an agreement by a third party to pay the lost principal and interest of a loan to you (the CDS buyer) if a borrower defaults on a loan. Which of the following is false?

A. A Swap completely solves the problem that company X might default

B. A Swap solves the default problem from Company X on the condition that the third party (CDS provider) will not default.

C. When financial crisis happens, the CDS seller may have to pay recovery to many CDS buyers, and then the CDS seller could default.

D. B and C are part of the reasons for 2008 Global financial crisis.

Answer 1

A swap is an exchange of payment so there remains the interest rate risk and also there is counterparty risk. Counterparty risk is the risk that other party will not full fill its obligation so the correct answer is

A. A SWAP completely solves the problem that the company X might default

With SWAP the counterparty risk remains so it does not solve the issue fully.

When SWAP is used with CDS then it solves the default problem or counterparty risk. It is also true that in times of crisis the CDS seller will have to compensate many CDS buyer and that might cause financial strain on them and can cause bankruptcy. For 2008, crisis there were many factors and the use of derivative was a key factor so option D is partially true.