- CFA Exams
- CFA Level I Exam
- Topic 6. Fixed Income
- Learning Module 30. Credit Default Swaps
- Subject 2. Credit Events and Settlement Protocols
CFA Practice Question
There are two series of outstanding senior bonds issued by a company, which has filed for bankruptcy. Bond A trades at 20% of par, and Bond B trades at 30% of par. Investor X owns $10 million of bond A and investor Y owns $10 million of bond B. They both own $10 million of CDS protection.
B. cash settlement.
C. no preference. Either one would yield the same result.
Which settlement method would investor Y prefer?
A. physical settlement.
B. cash settlement.
C. no preference. Either one would yield the same result.
Correct Answer: B
Physical settlement: Y would deliver $10 million Bond B for $10 million cash.
Cash settlement: Y would receive $8 million, and sell Bond B for $3 million. Total proceeds: $8 + $3 = $11 million.
User Contributed Comments 6
| User | Comment |
|---|---|
| davcer | Cheapest to deliver obligation |
| Rivermax | Why would Y receive $8mn and not $7mn given he owns bond B? |
| dada | @Rivermax: Bond A is the cheapest to deliver obligation, so the recovery rate for both CDS protection is 20%. So Y will get 8 million on his CDS contract, plus 3 million to sell Bond B. |
| Truesilver | Why would bonds issued by the same company(=same credit risk) trade differently? |
| Rva100 | @Truesilver bonds can have different seniority, so if bond B is senior, the holders of this bond will be paid first. That makes bond B more valuable. |
| CFAJ | can't investor Y just acquire bond a and settle with that also making both equivalent. isn't that literally the whole idea behind cheapest to delive |