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David

I picked this one up from the PRM set of questions:

A firm has two outstanding bond issues: a 6 percent coupon bond with one year to maturity

trading at a spread of 88 bps over Treasuries and a 9 percent coupon bond with ten years to

maturity trading at a spread of 340 bps over Treasuries. The one-year and ten-year Treasuries

are trading at 4% and 5% respectively. Both the bonds rank pari passu and have an estimated

recovery rate of 30%. What is the minimum upfront premium that a dealer will charge to sell a

one year credit swap to an owner of the 10-year bond?

A. 85 basis points.

B. 88 basis points.

C. 327 basis points.

D. 340 basis points.

The answer is simplistic: (considering that reading the question takes a couple of minutes!!!)

18. Correct answer: A

Since all the bonds rank equally, they would default at the same time. Therefore, the dealer

could hedge a one-year credit swap on the firm (for whichever bond) by selling the one-year

bond and purchasing one-year Treasuries. This results in a cost of 88 bps at the end of the

year, or 85 bps upfront {= 88 / (1 + 4%)}.

This seems an intelligent question, and and I am curious to know how to interpret the answer.

(How can equal ranking mean that they would default at the same time?)- unless it is a credit event.

Thanks as always

J

I picked this one up from the PRM set of questions:

A firm has two outstanding bond issues: a 6 percent coupon bond with one year to maturity

trading at a spread of 88 bps over Treasuries and a 9 percent coupon bond with ten years to

maturity trading at a spread of 340 bps over Treasuries. The one-year and ten-year Treasuries

are trading at 4% and 5% respectively. Both the bonds rank pari passu and have an estimated

recovery rate of 30%. What is the minimum upfront premium that a dealer will charge to sell a

one year credit swap to an owner of the 10-year bond?

A. 85 basis points.

B. 88 basis points.

C. 327 basis points.

D. 340 basis points.

The answer is simplistic: (considering that reading the question takes a couple of minutes!!!)

18. Correct answer: A

Since all the bonds rank equally, they would default at the same time. Therefore, the dealer

could hedge a one-year credit swap on the firm (for whichever bond) by selling the one-year

bond and purchasing one-year Treasuries. This results in a cost of 88 bps at the end of the

year, or 85 bps upfront {= 88 / (1 + 4%)}.

This seems an intelligent question, and and I am curious to know how to interpret the answer.

(How can equal ranking mean that they would default at the same time?)- unless it is a credit event.

Thanks as always

J

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