CFA Level I · CFA Level I Exam · Forward Commitment and Contingent Claim Features and Instruments
A credit default swap has a notional of $10 million. A credit event occurs, and the cheapest-to-deliver bond of the reference entity is valued at 40% of par in the auction. Assuming cash settlement, the payment from the protection seller to the protection buyer is closest to:
The cash settlement equals notional times one minus the recovery rate, so 10 million times 0.60 equals $6.0 million. The 40% recovery value of $4.0 million is what the bondholder retains, not what the protection seller pays.
- A$4.0 million
- B$6.0 millionCorrect
- C$10.0 million
Explanation
Payout = notional × (1 − recovery rate) = 10 million × (1 − 0.40) = $6.0 million. The $4.0 million figure is the recovery value, which uses the wrong base; $10 million ignores recovery.
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