medium · FRM Part 2 Credit Risk
An investor holds a First-Passage Default swap on a basket of three names. The investor's credit officer argues that the swap is 'long volatility.'
Which of the following best clarifies this statement in the context of the Merton model?
- The swap is actually 'short volatility', since volatility clustering across the three underlying names erodes the basket's diversification benefits.
- Higher asset volatility raises the risk-neutral hazard rate for each name, which in turn reduces the present value of the swap's fixed premium leg over its life.
- Higher asset volatility increases the probability that the diffusion process reaches the default barrier, raising the expected payout for the protection buyer.
- Volatility in credit markets is almost always accompanied by widening spreads, and it is specifically these wider spreads that raise the cost of the premiums paid.
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