FRM Part II · FRM Exam Part II · Credit Risk
A CDS on Corporation Z has a notional of USD 20 million, a spread of 150 basis points paid annually, and a standard recovery assumption. Z defaults and the final auction recovery price is 35% of par. What is the payment the protection seller makes at settlement, ignoring accrued premium?
The protection seller pays USD 13.0 million. Settlement equals notional times one minus the recovery rate, so 20 million times 65 percent. The 7 million figure is the recovery value, and the 0.3 million is merely one year's premium, not the default payout.
- AUSD 13.0 millionCorrect
- BUSD 7.0 million
- CUSD 20.0 million
- DUSD 0.3 million
Explanation
Physical or cash settlement pays par minus recovery: 20 million x (1 - 0.35) = 13.0 million. USD 7.0 million is the recovery amount, using the wrong side. USD 20 million ignores recovery. USD 0.3 million is the annual premium (1.5% x 20 million), which is not the settlement payment.
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