Practice Quiz

FRM Financial Risk Manager Practice Test

Category - Contract

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You are a hedge fund and you enter a contract which involves 3 players: You, the American Bank and WePro Ltd. The American Bank lends $1,000 to WePro and they want you to share the risk in case WePro fails to pay back. If you give the American Bank $1,000, you will get a fixed monthly payment worth 10% of $1,000 for the duration of the contract-as long as WePro doesn’t default. However, if WePro defaults on its debt, you will have to pay $1,000 to the American Bank and the contract is terminated. What type of contract is this?
  1. Credit default swap.
  2. Long-term loan.
  3. Hedging.
  4. Insurance.
Explanation
This type of contract is a credit default swap (CDS). It is a derivative contract in which the buyer of the CDS--the American Bank--makes a series of payments to the seller--you--and, in exchange, receives a payoff if WePro Ltd. fails to pay the loan. A CDS is a way to protect from losses when bonds default. It transfers the credit risk to another party while keeping the loan on its books.

Key Takeaway: Think of owning a CDS as owning an insurance policy on the failure of a company to repay a bond.
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