Impact of Credit Default Swap on Firm's Credit Risk

Medium Credit Analysis And Valuation Credit Derivatives

A seasoned credit analyst is evaluating a corporate entity that has issued a series of bonds. The analyst is particularly interested in assessing the firm's credit risk and has come across information regarding its use of credit derivatives.

Specifically, the firm has entered into a credit default swap (CDS) where it pays an annual premium and receives protection against the default of its bond obligations. The analyst wants to understand the implications of this derivative on the firm's credit exposure and overall credit quality.

Which of the following statements best describes the effect of the credit default swap on the firm's credit risk profile?

The CDS reduces the firm's credit risk exposure by transferring the risk of default to the counterparty.

The CDS has no impact on the firm's actual credit exposure but improves its credit rating due to the perceived risk reduction.

The CDS increases the firm's credit risk exposure by obligating the firm to pay premiums, thus deteriorating its cash flow position.

Hint

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