Impact of CDS on Bond Valuation

Very Hard Credit Analysis And Valuation Credit Derivatives

Venture Holdings, a mid-sized corporate entity, has issued a series of bonds which are currently trading at a significant premium to par due to the company's strong cash flows and low default risk. Recently, Venture Holdings has engaged in acquiring Credit Default Swap (CDS) protection for its corporate debt, believing that it would help manage potential credit risk and enhance portfolio returns.

The CDS contracts are structured to pay the bondholder a certain amount if Venture Holdings defaults. The market has witnessed increased volatility due to shifts in credit spread expectations, influenced by macroeconomic indicators. Analysts are now divided on the implications of Venture’s decision to utilize CDS— some believe it's a prudent risk management strategy, whereas others think it may signal underlying weaknesses in the company's financial outlook.

Considering the nature of credit derivatives and the associated risk factors, which of the following statements regarding the impact of CDS on bond valuation and risk exposure is most accurate?

The inclusion of CDS protection generally decreases the risk premium required by investors, leading to higher bond valuations.

The purchase of CDS protection increases the likelihood of bondholder recovery in a default scenario but does not affect the fundamental valuation of the bonds.

The existence of a CDS market effectively eliminates any credit risk associated with the underlying bonds.

Hint

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