You are currently long $10,000,000 par value, 8% XYZ bonds. To hedge your position, you must decide between credit protection via a 5-year CDS with 60bp annual premiums or digital swap with 50% payout with 50bp annual premiums. After one year, XYZ has defaulted on its debt obligations and currently trades at 60% of par. Which of the following statements is true?
A. The contingent payment from the protection buyer to the protection seller is greater under the single-name CDS than the digital swap.
B. The contingent payment from the protection buyer to the protection seller is less under the single-name CDS than the digital swap.
C. The contingent payment from the protection seller to the protection buyer is greater under the single-name CDS than the digital swap.
D. The contingent payment from the protection seller to the protection buyer is less under the single-name CDS than the digital swap.
Answer:C
Choices A and B can be eliminated because payments in default are made from protection seller to protection buyer. The payoff from the digital swap will be 50% of par value while the payoff from the single name will be 40% (i.e., 1-0.6) of par value.

 
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