CFA Level I · CFA Level I Exam · Credit Risk
An investor holds a bond with a 2% annual probability of default over one year. Loss given default is 55% of a €5,000,000 position. A credit default swap hedges the exposure at a cost of 0.90% of notional per year. Relative to the one-year expected loss, the annual hedge cost is:
The hedge cost is €10,000 lower than expected loss. Expected loss is 2% × 55% × €5,000,000 = €55,000, while the swap costs 0.90% × €5,000,000 = €45,000. The difference is €10,000 in favor of the hedge.
- A€10,000 lower than expected lossCorrect
- B€10,000 higher than expected loss
- C€45,000 lower than expected loss
Explanation
Expected loss = 0.02 × 0.55 × 5,000,000 = €55,000. Hedge cost = 0.009 × 5,000,000 = €45,000. The cost is €10,000 below expected loss. The €45,000 option confuses the cost with the difference, and the higher option reverses the sign.
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