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FRM Part II · FRM Exam Part II · Credit Derivatives

An investor buys USD 20 million of protection on a CDS index with a fixed coupon of 100 bp per year. The index trades at an upfront-adjusted spread, and a market-implied index spread of 140 bp with a risky annuity of 4.5 implies the upfront payment. Ignoring accrued interest, what upfront amount does the protection buyer pay?

The buyer pays USD 360,000 upfront. The market spread of 140 bp exceeds the 100 bp coupon by 40 bp, and multiplying that difference by the risky annuity of 4.5 and the USD 20 million notional gives 0.004 x 4.5 x 20 million = USD 360,000.

  1. AUSD 360,000Correct
  2. BUSD 56,000
  3. CUSD 90,000
  4. DUSD 252,000

Explanation

Upfront = (market spread - fixed coupon) x risky annuity x notional = 0.0040 x 4.5 x 20,000,000 = 360,000. The buyer pays because the market spread exceeds the coupon. USD 90,000 uses a 1-unit annuity and wrong spread difference of 0.0045... in effect omits the annuity multiple scaling; 252,000 wrongly uses 140bp x 4.5 x... partially.

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