FRM Part II · FRM Exam Part II · Credit Derivatives
A credit event occurs on a reference entity. The CDS notional is USD 20 million, the cheapest-to-deliver bond trades at 40% of par after the event, and the contract is cash settled using the auction price. What is the payout from the protection seller to the buyer?
The seller pays USD 12 million. Cash settlement equals notional times one minus the auction recovery price: 20 million times 60%. USD 8 million wrongly pays the recovery value rather than the loss.
- AUSD 8 million
- BUSD 12 millionCorrect
- CUSD 20 million
- DUSD 40 million
Explanation
Payout = notional x (1 - recovery rate) = 20 million x (1 - 0.40) = USD 12 million. USD 8 million is notional times recovery, a common error. USD 20 million ignores recovery.
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