Understanding Credit Default Swaps and Risk Implications

Hard Credit Analysis And Valuation Credit Derivatives

A fixed income analyst is evaluating the credit risk of a corporate bond issued by Alpha Corp., which has recently entered into a credit default swap (CDS) to hedge against potential defaults. The CDS contract specifies that in the event of a credit event, the protection seller will pay the protection buyer the notional amount of the bond in exchange for the underlying bond, assuming that the buyer has adequately met all of the contract conditions.

The analyst is interested in examining the implications of this CDS for Alpha Corp.'s overall internal risk profile and liquidity position. The analyst knows that the CDS premium has increased significantly over the past quarter, reflecting market concerns about Alpha Corp's creditworthiness.

Based on this scenario, which of the following statements best describes the role and impact of the CDS in this context?

The increase in the CDS premium indicates that the market perceives a higher risk of default for Alpha Corp., which has a negative impact on its overall risk profile.

The CDS acts as a strong liquidity buffer for Alpha Corp., allowing it to maintain its capital structure despite the increased premium.

The CDS effectively eliminates all credit risk associated with the bond, allowing Alpha Corp. to ignore potential default scenarios.

Hint

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