Forward Commitments and Contingent Claims: practice question

Meridian Commercial Bank holds a $10 million senior loan to a distressed packaging maker and buys five-year credit default protection on the borrower from Dunmore Assurance. Meridian will pay 300 basis points of the notional per year, and Dunmore has committed to compensate Meridian if a defined credit event, such as a bankruptcy filing by the borrower, occurs during the term. Which statement about the two parties' obligations is most accurate?

1. Both parties owe scheduled cash flows, because the contract commits them to an exchange of payments like a fixed-for-floating swap
2. Meridian owes its spread payments on schedule, while Dunmore owes a payment only if the defined credit event occurs
3. Dunmore owes the spread payments, and Meridian owes the contingent payment if the borrower defaults on the loan

Show answer and explanation

Correct answer: B

Explanation: B is correct. The protection buyer's spread payments are unconditional contractual obligations, while the protection seller owes nothing unless the defined credit event occurs — one leg is contingent on the outcome, which is what makes a credit default swap a contingent claim. A is incorrect because only one side of this contract owes scheduled payments; in a swap both legs are binding on every settlement date, whereas here the seller's payment is triggered by an event rather than scheduled. C is incorrect because it reverses the parties' roles: Dunmore sold the protection, so it receives the spread and owes the payment if the credit event occurs, not the other way around.