Understanding Credit Default Swaps in Distress

Very Hard Credit Analysis And Valuation Credit Derivatives

In the context of credit derivatives, particularly credit default swaps (CDS), consider an investor who holds a long position in a CDS contract for a corporate bond. The reference entity is expected to undergo a considerable financial distress scenario, and the market is pricing the CDS with a high implied probability of default.

Which of the following statements about the investor's position and the CDS contract is most accurate?

The investor faces unlimited downside risk as the value of the CDS can decline significantly if the reference entity does not default.

The premium paid for the CDS will increase over time, regardless of changes in the creditworthiness of the reference entity.

If the reference entity defaults, the investor can sell the CDS for its recovery value, which depends on the market value of the underlying obligation.

Hint

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