FRM Part II · FRM Exam Part II · Credit Risk
A CDS on a corporate bond has a notional of USD 20 million and a quoted spread of 250 basis points per year, paid annually for simplicity. The reference bond defaults and its recovery rate is 40%. What is the protection buyer's payoff from the credit event settlement (ignoring accrued premium)?
The protection buyer receives USD 12 million. The payoff on a credit event equals the notional times one minus the recovery rate, so 20 million times 60 percent. The 250 basis point spread determines the premium paid, not the settlement.
- AUSD 8 million
- BUSD 12 millionCorrect
- CUSD 20 million
- DUSD 0.5 million
Explanation
Payoff = notional x (1 - recovery) = 20 x 0.6 = USD 12 million. USD 8 million is the recovery value, which is a wrong-base error. The spread of 250 bp only determines premiums, not the settlement amount.
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