FRM Part II · FRM Exam Part II · Credit Derivatives
A bank buys five-year protection on a reference entity through a credit default swap with a quoted spread of 120 basis points per year. Which statement best describes the CDS spread in a simple, no-frills pricing framework?
The CDS spread is the annual premium that equates the present value of expected premium payments with the present value of expected protection payments at inception, so the contract starts with zero value. It is not simply a bond spread or an undiscounted expected loss.
- AIt is the annual premium, as a percentage of notional, that makes the present value of expected protection payments equal to the present value of expected premium payments at inceptionCorrect
- BIt is the reference entity's bond yield minus the risk-free rate, regardless of the recovery rate
- CIt is the expected annual loss on the notional, with no discounting or survival probabilities involved
- DIt is the upfront payment the protection buyer makes so that no running premium is needed
Explanation
At inception a CDS is priced so the present value of premium leg equals the present value of the protection leg, giving zero initial value. The bond-yield option describes an approximate link, not the definition. Expected-loss-only pricing ignores timing and discounting, and the upfront option describes a different convention.
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