Question 2. (8 pts) Consider a credit default swap (CDS) of a notional amount $1

Question

Question 2. (8 pts) Consider a credit default swap (CDS) of a notional amount $10 million and a term of one year. The CDS spread is 120 basis points and the payment is quarterly. The credit event is a default on the bond. The seller is A and the buyer is B.

(1) (4 pts)If the bond has not defaulted, calculate the payment from B to A in the first quarter of the contract.

(2) (4 pts) Suppose that there is default on the bond in the fourth quarter immediately after the premium in the quarter is paid but before the contract expires. If the recovery value of the bond is 20% of the par value, calculate the payment from A to B in a cash settlement.

Explanation / Answer

answer 1) If the bond has not defaulted, the payment from B to A in the first quarter of the contract will be 10$/4=2.5$

answer 2)payment=( 1-recovery rate)*notional value

=(1-0.20)*10

=.80*10

=8$

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