FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
A bank buys credit protection on USD 20 million notional of a corporate bond portfolio from a protection seller through a CDS. The recovery rate on default is 40%. The reference entity defaults and the contract is cash settled. What payment does the protection seller make to the bank?
The protection seller pays USD 12 million. A CDS payout equals notional multiplied by one minus the recovery rate, so 20 million times 60% gives 12 million. Using the 40% recovery as the loss would wrongly give 8 million.
- AUSD 8 million
- BUSD 12 millionCorrect
- CUSD 20 million
- DUSD 40 million
Explanation
The seller pays notional times (1 - recovery rate) = 20 million x (1 - 0.40) = USD 12 million. USD 8 million wrongly uses the recovery rate itself as the loss. USD 20 million ignores recovery.
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