Section 4

Question 1

What is an unfunded credit derivative?

Answer 1

is a bilateral contract between two counterparties where each is responsible for making payments and any cash or physical settlement under the contract is without resource to other contracts

Question 2

what is a funded credit derivative?

Answer 2

involves the protection seller making an intitial payment that is used to settle any potential credit event

Question 3

what is a credit default swap

Answer 3

• Someone else takes on the risk of default of a bond
• Bond holder pays premium to a counterparty for life of bond
• if bond doesn’t default the seller of the CDS keeps the premiums and has nothing to pay
• if the bond defaults the bondholder hands over the bond in return for its face value

Question 4

why do some people believe that Credit default swaps add to financial instability?

Answer 4

• Institutions can offload or hedge credit risks which may make them inclined to take on more risk than is optimal, particularly as asymmetric information may be a feature of this market
• They also facilitate taking speculative decisions regarding credit risk