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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 of a corporate bond at a spread of 150 bps per year, paid annually. In year 3 the reference entity defaults immediately after the annual premium for year 3 has been paid. The bond's recovery rate is 40%, and the contract is physically or cash settled at par less recovery. What is the net cash payment received by the bank at settlement, ignoring premiums already paid and discounting?

The bank receives USD 12.0 million. The CDS pays notional times one minus the recovery rate, which is 20 million times 60%. Premiums already paid are ignored, and the 40% recovery is the part of the bond value not compensated by the protection seller.

  1. AUSD 8.0 million
  2. BUSD 12.0 millionCorrect
  3. CUSD 11.7 million
  4. DUSD 20.0 million

Explanation

Payout = notional x (1 - recovery) = 20 x 0.60 = USD 12.0 million. USD 8.0 million is the loss with recovery applied wrongly (20 x 0.40). USD 11.7 million subtracts one premium (0.3m) wrongly, though premiums already paid are ignored. USD 20 million ignores recovery.

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