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Credit Default Swaps and Mutual Funds

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@DurableAlgorithm

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Questions and Answers

What is the primary purpose of allowing mutual funds to sell credit default swaps (CDS)?

To reduce the risk associated with equity investments.

To eliminate the need for periodic payments by buyers.

To aid liquidity growth in the corporate bond market. (correct)

To guarantee investors a fixed return on their investments.

How does the Credit Default Swap (CDS) primarily function?

It guarantees the repayment of the original investment.

It converts fixed income into variable income securities.

It protects against equity market fluctuations.

It transfers the credit risk of a debt instrument from the buyer to the seller. (correct)

What benefit will mutual funds gain from the ability to sell CDS?

Improved risk exposure to equities.

Guaranteed monthly income from the contracts.

Increased flexibility in managing credit risk. (correct)

Reduced regulatory compliance requirements.

What does the payment structure of a CDS typically resemble?

Regular premium payments similar to an insurance policy. Signup and view all the answers

Why was the ability to sell CDS not available previously to mutual funds?

Only purchasing CDS was permitted until the recent directive from SEBI. Signup and view all the answers

In a CDS contract, what does the seller provide to the buyer upon a credit event?

Face value of the debt instrument plus any unpaid interest. Signup and view all the answers

What regulatory directive preceded SEBI's decision to allow mutual funds to sell CDS?

Reserve Bank of India’s directive for a revised regulatory framework for debt derivatives. Signup and view all the answers

Study Notes

SEBI's Announcement on CDS

SEBI allows mutual funds to sell credit default swaps (CDS), enhancing liquidity in the corporate bond market.
This decision aligns with RBI's 2022 directive for a revised regulatory framework regarding debt derivatives.
Prior to this, mutual funds could only purchase CDS, limiting their operational flexibility.

Understanding Credit Default Swaps (CDS)

CDS are financial derivatives designed to transfer credit risk associated with debt instruments (e.g. bonds) between parties.
A CDS contract involves a buyer and a seller; the buyer pays periodic premiums to the seller for credit protection.
The seller provides compensation to the buyer if the underlying debt instrument defaults or if a specific credit event occurs (e.g. bankruptcy).
Compensation from the seller typically covers the face value of the defaulted debt instrument and any unpaid interest.

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Description

This quiz discusses the recent announcement by SEBI allowing mutual funds to sell credit default swaps (CDS). It explores the implications of this change for liquidity in the corporate bond market and the regulatory framework set by RBI. Test your understanding of CDS and its impact on financial instruments.