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FRM Part II · FRM Exam Part II · Credit Risk Management

An investor buys five-year CDS protection on a reference entity with a notional of USD 20 million at a spread of 150 bps per year, paid annually. Ignoring discounting and accrued premiums, the reference entity defaults at the end of year 2 immediately after the second premium payment. The recovery rate is 40% and settlement is by cash at the market price. What is the net cumulative cash result to the protection buyer (payout received minus premiums paid)?

The net result is USD 11.4 million. The protection payout is the notional times one minus the 40% recovery, which is USD 12 million, and the buyer paid two annual premiums of USD 0.3 million each, totaling USD 0.6 million, leaving USD 11.4 million.

  1. AUSD 11.4 millionCorrect
  2. BUSD 12.0 million
  3. CUSD 11.7 million
  4. DUSD 8.4 million

Explanation

Payout = 20m x (1 - 0.40) = 12.0m. Premiums = 20m x 1.5% x 2 = 0.6m. Net = 12.0 - 0.6 = 11.4m. Ignoring premiums gives 12.0m; paying only one premium gives 11.7m; using 40% as loss gives 8.0m minus premiums = 7.4m, and 8.4m results from mistakes in the loss.

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