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FRM Part II · FRM Exam Part II · Credit Derivatives

A CDS contract has a standardized fixed coupon of 100 bp, while the market spread for the reference entity is 250 bp. For a five-year contract with a risky annuity (PV01) of 4.2, what is the approximate upfront payment from the protection buyer, as a percentage of notional?

The buyer pays about 6.3% of notional upfront to the seller. The standardized coupon of 100 bp is below the 250 bp market spread, so the buyer compensates the seller for the 150 bp shortfall, multiplied by the risky annuity of 4.2.

  1. A6.3% paid by the buyer to the sellerCorrect
  2. B6.3% paid by the seller to the buyer
  3. C10.5% paid by the buyer to the seller
  4. D1.5% paid by the buyer to the seller

Explanation

Upfront = (market spread - fixed coupon) x risky annuity = (2.50% - 1.00%) x 4.2 = 6.3%. Because the coupon is below the market spread, the buyer underpays periodic premium and so pays the seller upfront. 10.5% uses the full spread instead of the difference.

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