Which of the following statements are true:

Which of the following statements are true:

I. A credit default swap provides exposure to credit risk alone and none to credit spreads

II. A CDS contract provides exposure to default risk and credit spreads

III. A TRS can be used as a funding source by the party paying LIBOR or other floating rate

IV. A CLN is an unfunded security for getting exposure to credit risk
A . I, III and IV
B . II, III and IV
C . II and IV
D . II and III

View Answer

Answer: D

Explanation:

A CDS contract provides exposure to default risk and the credit spread for a particular credit. It does not provide an exposure to the risk of interest rates going up or down. It is an instrument that allows institutions to take a view on the price of credit risk alone. Therefore statement I is false and statement II is true.

A total return swap (TRS) exchanges the return from an asset for a fixed or floating exchange rate. It is in essence a financing arrangement where one party pays the other interest to earn a return on an asset that it does not wish to hold itself, perhaps for liquidity reasons. The financed asset is held by the party paying the asset’s returns, effectively creating a ‘collateral’. Therefore statement III is correct.

A credit linked note is a funded instrument where the sellers of the protection have put up the money upfront in the form of a subscription to a note in case the credit losses are realized. Therefore statement IV is not correct.