A risk manager is advising the trading desk about entering into a digital credit default swap as a way to obtain credit protection. Which cash flow and delivery requirement will the desk most likely experience in the event of a default of the underlying reference asset?
a. Receive the pre-agreed cash payment; deliver nothing.
b. Receive [(Par Value) - (Market Value of Reference Asset)]; deliver the reference asset.
c. Receive [(Par Value) - (Market Value of Reference Asset)]; deliver nothing.
d. Receive the pre-agreed cash payment; deliver the reference asset.
Answer:A
A digital CDS will pay off a pre-determined fixed amount in the event of a default. Digital CDS are often used against highly illiquid reference assets that would be difficult to price.