FRM Part II · FRM Exam Part II · Credit Risk Management
A bank buys 5-year CDS protection on a USD 20 million notional at a spread of 150 bps per year, paid annually. The reference entity defaults and the post-default market price is 35% of par. Under physical or cash settlement, what is the protection seller's payout (ignoring accrued premium)?
The payout is USD 13.0 million. The protection seller pays notional times one minus the recovery rate, which is 20 million times 65 percent. The 35 percent recovery is retained value, not the loss, and the spread does not change the settlement amount.
- AUSD 7.0 million
- BUSD 13.0 millionCorrect
- CUSD 20.0 million
- DUSD 3.0 million
Explanation
Payout = notional x (1 - recovery) = 20 million x (1 - 0.35) = 13.0 million. The 7.0 million figure uses the recovery rate as the loss, which is the wrong base. The spread affects premium paid, not the settlement payout.
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