FRM Part II · FRM Exam Part II · Derivatives
A bank buys five-year protection on a corporate reference entity through a single-name credit default swap with a notional of USD 10 million. The CDS spread is 200 basis points per year, paid quarterly. Ignoring accrual conventions and discounting, what is the approximate annual premium the bank pays?
The protection buyer pays about USD 200,000 per year, because the annual premium equals the notional of USD 10 million multiplied by the 2 percent spread. Quarterly payments are roughly USD 50,000 each, before accrual and discounting adjustments.
- AUSD 20,000
- BUSD 200,000Correct
- CUSD 2,000,000
- DUSD 500,000
Explanation
Annual premium = notional x spread = 10,000,000 x 0.02 = USD 200,000, paid as about USD 50,000 per quarter. USD 20,000 results from treating 200 bp as 0.2%. USD 500,000 mistakenly uses 5 years or the wrong quarterly scaling.
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