a. Consider a hypothetical scenario where you have a default-free floating rate bond and a corporate floating rate bond with maturities of 5 years. The current default- free floating rate is 4% and the corporate floating rate is 6%. While the rates are quoted annually, both bonds pay coupons semi-annually. The face value of both bonds is $100. Describe step-by-step how you would set up the positions (long and short) to mimic the cash flows of a credit default swap. What would be the CDS rate? b. Assume the "loss given default” is $40 in the problem above. Suppose the loss given default changes and becomes $60. How would the CDS rate change given the increase in "loss given default." c. Suppose the probability of default before 5 years is 2% in the above problem. Now imagine that the probability of default falls to 1%. How would the CDS rate change?
a. Consider a hypothetical scenario where you have a default-free floating rate bond and a corporate floating rate bond with maturities of 5 years. The current default- free floating rate is 4% and the corporate floating rate is 6%. While the rates are quoted annually, both bonds pay coupons semi-annually. The face value of both bonds is $100. Describe step-by-step how you would set up the positions (long and short) to mimic the cash flows of a credit default swap. What would be the CDS rate? b. Assume the "loss given default” is $40 in the problem above. Suppose the loss given default changes and becomes $60. How would the CDS rate change given the increase in "loss given default." c. Suppose the probability of default before 5 years is 2% in the above problem. Now imagine that the probability of default falls to 1%. How would the CDS rate change?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:a. Consider a hypothetical scenario where you have a default-free floating rate bond
and a corporate floating rate bond with maturities of 5 years. The current default-
free floating rate is 4% and the corporate floating rate is 6%. While the rates are
quoted annually, both bonds pay coupons semi-annually. The face value of both
bonds is $100. Describe step-by-step how you would set up the positions (long and
short) to mimic the cash flows of a credit default swap. What would be the CDS
rate?
b. Assume the "loss given default” is $40 in the problem above. Suppose the loss
given default changes and becomes $60. How would the CDS rate change given the
increase in "loss given default."
c. Suppose the probability of default before 5 years is 2% in the above problem. Now
imagine that the probability of default falls to 1%. How would the CDS rate change?
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