Q1 In the case of pure credit swaps by which a financial institution (Fl) sells a credit forward:

a.The spread can only decrease to zero, therefore the forward buyer has limited loss exposure similar to the premium on a put option.

b.If the credit risk of the borrower deteriorates sufficiently that the spread over the benchmark bond increases, the forward seller (the FI) will pay the forward buyer.

c.The spread can only decrease to zero, therefore the Fl has limited loss exposure similar to the premium on a put option.

d.If the credit risk of the borrower improves, the forward buyer will pay the forward seller (the Fil) because the benchmark spread will have decreased.

Q2 Which statement is incorrect?

a. A digital default option pays a stated amount in the event of a loan default. If the loan is repaid in its entirety, the option expires unexercised.

b. A credit spread call option has a payoff that increases as the yield spread against some specified benchmark bond increases above the exercise spread. The increased payoff compensates the lender for decreases in value caused by an increase in the credit risk of the borrower.

Q3 Which statement is incorrect?

a. A digital default option pays a stated amount in the event of a loan default. If the loan is repaid in its entirety, the option expires unexercised

b. A credit spread call option has a payoff that increases as the yield spread against some specified benchmark bond increases above the exercise spread. The increased payoff compensates the lender for decreases in value caused by an increase in the credit risk of the borrower.

c. The total return swap includes an element of interest rate risk, while the pure credit swap has stripped this risk from the contract

d. In a pure credit swap the premium payment on the swap is paid at maturity, while the fees of a default option are paid over the life of the default option