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FRM Part II · FRM Exam Part II · Credit Risk

An investor buys five-year protection on a reference entity with a CDS notional of USD 20 million at a spread of 150 basis points per year, paid annually. Ignoring discounting and accrued premium, the reference entity defaults at the end of year 2 immediately after the second premium payment, and the recovery rate is 40%. What is the net cash result to the protection buyer over the life of the contract, counting the two premiums paid and the protection payment?

The net gain is USD 11.4 million. The protection payment is notional times loss given default, 20 million times 60 percent, or 12 million. The buyer paid two annual premiums of 0.3 million each, totalling 0.6 million, which is deducted from the payout.

  1. ANet gain of USD 11.4 millionCorrect
  2. BNet gain of USD 8.4 million
  3. CNet gain of USD 12.0 million
  4. DNet gain of USD 11.8 million

Explanation

Payout = 20m x (1 - 0.40) = USD 12.0m. Annual premium = 20m x 1.5% = USD 0.3m, and two premiums total USD 0.6m. Net = 12.0 - 0.6 = USD 11.4m. Ignoring the premiums gives 12.0m; using recovery as loss gives 8.0m, and subtracting 0.6 from 8.0 gives 7.4m.

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