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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank buys 5-year CDS protection on USD 20 million notional at a spread of 150 basis points per year, paid annually. After two years the reference entity defaults, with a recovery rate of 40% on the reference obligation, and the contract is settled in cash immediately after the default event (ignore accrued premium and discounting). What is the protection payout received by the bank?

The payout is USD 12 million, calculated as the notional of USD 20 million times one minus the 40% recovery rate. The spread only determines the annual premium of USD 0.3 million and does not affect the settlement amount.

  1. AUSD 8 million
  2. BUSD 12 millionCorrect
  3. CUSD 20 million
  4. DUSD 0.3 million

Explanation

Payout = notional x (1 - recovery) = 20 million x 0.60 = USD 12 million. Using the recovery rate itself (USD 8 million) is the wrong-base mistake. The premium of USD 0.3 million (20m x 1.5%) is the annual cost, not the payout.

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