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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A trader approximates the CDS spread using the credit triangle. A reference entity has an annual hazard rate of 3% and an expected recovery rate of 40%. The trader then buys protection on $25 million notional for one year (ignoring accrual and discounting details) at that spread. Which statement is correct?

The spread is about 180 basis points and the annual premium about $450,000. The credit triangle sets spread equal to hazard rate times loss given default, 3% times 60% equals 1.8%, and 1.8% of $25 million is $450,000.

  1. AThe spread is about 180 bp and the annual premium is about $450,000Correct
  2. BThe spread is about 300 bp and the annual premium is about $750,000
  3. CThe spread is about 120 bp and the annual premium is about $300,000
  4. DThe spread is about 180 bp and the annual premium is about $750,000

Explanation

Spread ≈ hazard rate × (1 − recovery) = 0.03 × 0.60 = 1.80% = 180 bp. Premium = 0.018 × $25,000,000 = $450,000. Using 300 bp ignores loss given default; 120 bp uses recovery instead of LGD.

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