AIM 3: Compute the value of credit default swaps, given unconditional default probabilities, survival probabilities, market yields, recovery rates and cash flows.

1、The survival probabilities and unconditional default probabilities for Bote Corp are listed in the table below. Baltimore Bay Investments has entered into a 4-year credit default swap (CDS) with Phili Investments to hedge against the credit risk of a $50 million bond issued by Bote Corp. Assume that payments on the CDS occur annually at the end of the year, and that defaults on the CDS occur halfway through each year. The risk-free rate is 6 percent, compounded continuously, and the recovery rate in the event that Bote Corp defaults is 40%. The probability that Bote Corp defaults during a year, conditional on no-earlier default is 2 percent.

Which of the following is closest to the present value of the total expected payments made by the buyer of the CDS?

A)    3.28s.

B)    3.98s

C)   5.61s

D)   3.32s.

The correct answer is D

The total value of expected payments made by the buyer of the CDS includes both the payments based on the spread and the expected accrual payment. Both are shown in the tables below.

PV of expected payments:

PV of the accrual payments in the event of default:

Present value of total expected payments = 3.2864s + .0335s = 3.3199s

2、Which is the following is closest to the present value of the payoff in the event that Bote Corp defaults?

A) 0.0335.

B) 0.0201.

C) 0.0317.

D) 0.0415.

The correct answer is D

Present value of the expected payment in the event of default:

The present value of the expected payment in the event of default is .0415.

3、Which of the following best approximates the CDS spread for the 4-year CDS?

A) 273 basis points.

B) 157 basis points.

C) 125 basis points.

D) 172 basis points.

The correct answer is C

Equate the present value of total payments to the present value of the expected payoff in the event of default.

3.3199s = .0415, s = .0125, or 125 basis points.

4、A 4-year credit default swap (CDS) specifying physical delivery defaults at the end of two years. If the reference asset is a $100 million, 8.0% ABC corporate bond, and the CDS spread is 125 basis points, the buyer of the CDS will:

A) receive payments of 800 basis points for the next two years.

B) receive a payment of $167.5 million.

C) continue to receive payments of 675 basis points for the next two years.

D) deliver the bond and receive a payment of $100 million.

The correct answer is D

If the swap specifies physical delivery, the buyer of the swap will deliver the reference obligation to the seller and receive the par value of the obligation.

AIM 6: Identify and explain functions and uses of total return swaps.

1、An analyst is examining the cash flows of a total return credit swap. Which one of the following statements regarding total return credit swaps is least accurate?

A) The swap buyer receives any gain or loss of the underlying asset and assumes its credit risk.

B) The swap seller’s cash inflow equals LIBOR plus or minus a spread.

C) The swap seller eliminates its credit risk exposure.

D) The swap buyer assumes ownership of the reference asset.

The correct answer is D

The swap seller retains ownership of the reference assets and is required to pay any financing costs associated with the reference asset.

2、Which of the following statements concerning the buyer of a total return swap is TRUE? The swap buyer:

A) does not assume any of the asset’s credit risk.

B) receives the total return of the reference asset.

C) purchases the underlying asset.

D) receives LIBOR plus a spread.

The correct answer is B

Since the swap buyer receives the total return of the reference asset, she assumes the asset’s credit risk. The swap buyer does not purchase the underlying asset and pays LIBOR + a spread.