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CA Final · Advanced Financial Management · Risk Management

Vihaan Bank has a Rs 100 crore loan to a single borrower. It buys a one-year CDS giving protection on 80% of the loan, at a premium of 1.8% of the protected notional. The bank assumes PD of 5% and LGD of 50% on the whole loan. The protection seller is assumed to be default-free. What is the bank's expected loss net of the CDS payout, ignoring the premium, and what is the premium cost?

Unhedged expected loss is 5% x 50% x Rs 100 crore = Rs 2.5 crore. With 80% protected, the retained expected loss is Rs 0.5 crore. The premium is 1.8% on the protected Rs 80 crore, which is Rs 1.44 crore.

  1. AExpected loss Rs 0.5 crore; premium Rs 1.44 croreCorrect
  2. BExpected loss Rs 0.5 crore; premium Rs 1.8 crore
  3. CExpected loss Rs 2.0 crore; premium Rs 1.44 crore
  4. DExpected loss Rs 2.5 crore; premium Rs 1.44 crore

Explanation

Unhedged expected loss = 0.05 x 0.5 x 100 = Rs 2.5 crore. The CDS covers 80% of the loss, so the retained loss is 20% x 2.5 = Rs 0.5 crore. Premium = 1.8% x 80 = Rs 1.44 crore. Rs 1.8 crore applies the premium to the full loan; Rs 2.5 crore ignores the hedge.

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