Chartered Institute of Stockbrokers (CISI) Professional Practice Exam

If Company A pays Company B to recompense it if one of its investments falls in value, what is this known as?

1. Hedging contract

2. Credit default swap

3. Derivatives agreement

4. Investment guarantee

The correct answer is: Credit default swap

The situation described involves Company A paying Company B to provide compensation in the event that one of its investments decreases in value. This aligns with the characteristics of a credit default swap (CDS). A credit default swap is a financial derivative that allows an investor to "swap" or transfer the credit exposure of fixed income products between parties. Essentially, it acts as a form of insurance against the default of a borrower or a decline in the value of an investment. In the context presented, Company A’s payment to Company B is for a promise of compensation if a specific risk materializes—in this case, a drop in the investment's value. The person or entity that pays the premium (Company A) is essentially seeking protection against credit risk, which is a fundamental purpose of a CDS. This financial instrument allows banks and other financial institutions to manage risk more effectively. The other options, while related to risk management, do not precisely describe the action taking place in this scenario. For instance, a hedging contract generally encompasses a broader range of financial instruments used to offset risk, while a derivatives agreement encompasses a variety of instruments including options and futures, not specifically tailored to credit risk. An investment guarantee, though it might imply a similar outcome, is typically framed as