CFA Level I · CFA Level I Exam · Forward Commitment and Contingent Claim Features and Instruments
A credit default swap has a notional principal of $10 million and a standard coupon of 1% per year. After a credit event, the auction-determined recovery rate on the cheapest-to-deliver bond is 40%. The payment made by the protection seller under cash settlement is closest to:
The payout is about $6.0 million. In cash settlement the protection seller pays notional multiplied by one minus the recovery rate, so $10 million × 60% equals $6.0 million. Using the 40% recovery rate directly would wrongly give $4.0 million, which is the amount recovered, not the loss.
- A$4.0 million
- B$6.0 millionCorrect
- C$9.9 million
Explanation
The payout equals notional times loss given default, which is (1 − recovery rate). That gives $10 million × (1 − 0.40) = $6.0 million. The $4.0 million option mistakenly uses the recovery rate itself instead of the loss.
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