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P2.T6.208. Credit Derivatives (Credit default swap)

Suzanne Evans

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208.1. A new 2-year credit default swap (CDS) references a bond with an annual conditional default probability of 10.0%. The estimated recovery rate is 50.0%. The riskfree zero curve is flat, for all maturities, at 4.0% per annum with continuous compounding. Payments are made annually and defaults are assumed to occur half-way through each year, at which time accrued protection payment is due. Which is nearest to the CDS spread?

a. 177 basis points
b. 201 basis points
c. 536 basis points
d. 1,072 basis points

208.2. Suppose the corporate bond of Acme Corporation earns a yield of 5.0% per annum when the risk-free rate is 2.0% per annum. Further, the asset-swap spread happens to be 3.0% such that the asset-swap spread is equal to the excess of the corporate bond's yield over the risk-free rate. Also, a credit default swap (CDS) that references the bond trades exactly where we might expect: the CDS spread is 300 basis points. The CDS-bond basis = CDS spread - asset swap spread and, in this case, the CDS-bond basis equals zero. Put another way, a long position in the corporate bond hedged by a long CDS (buying protection) generates annual income equal to the risk-free rate, as 500 bps yield minus 300 bps CDS spread nets 200 bps income. Each of the following should INCREASE the CDS-bond basis EXCEPT for:

a. A decrease in counterparty risk assumed by the CDS protection buyer as the credit quality of the protection seller increases
b. Hedge fund speculators, who are bearish on Acme, seek to short Acme's credit. They express this view with by trading credit default swaps.
c. There is an decrease in the market's funding cost; i.e., the borrowing cost to fund the purchase of Acme's bond (funding cost is included in the asset swap spread)
d. An increase in wrong-way risk between the CDS protection seller and the underlying reference (Acme's corporate bond)

208.3. The fundamental valuation of a credit default swap (as illustrated by Hull) determines the CDS spread by solving for a spread (s) that equates the present value of expected protection payments to the present value of the expected, contingent payoff by the protection seller. Which of the following is likely to cause the highest increase in (have the greatest impact on) the CDS spread?

a. An increase in real-world default probabilities
b. An increase in risk-neutral default probabilities
c. An increase in recovery rate where the same recovery rate is used to both estimate the risk-neutral default probability and to estimate the contingent payoff
d. An increase in the riskfree rate

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