Given the following:

The yield on a five-year, risk-free Treasury-note = 5%

The yield on a five-year, BB-quality bond = 8%, with the 3% spread reflecting only credit risk

The credit spread on a five-year CDS on the 5-year, BB-quality bond of 2%

a. Explain how a bond investor looking for a five-year, risk-free investment could gain a 1% yield over the risk-free investment by using a CDS.

b. Explain what an arbitrageur would do.

c. Comment on the impact the actions by investors and arbitragers would have on determining the equilibrium spread on a CDS.

Answer rating: 100% (QA)

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