Ian Maxwell is the chief investment officer for Glasgow’s municipal workers’ pension funds (GMWF). He is intrigued by the high-yielding sovereign debt issued by PIIGS countries. Most notably, Spain just issued five-year treasury bonds at par paying a coupon of 6. 25 percent. Spain as a sovereign is rated B but credit default swaps (CDSs)

on Spanish debt for an annual premium of 285 basis points are available from AXA—an AA-rated French insurance company.

a. What is a CDS on sovereign debt? How does it differ from CDSs on corporate debt?

b. Spell out the cash flows—timing and amount—between GMWF and AXA, assuming that Spain does not default.

c. A referendum held in Catalonia in December 2013 leads to Catalonia seceding from Spain and precipitating Spain into default by the close of 2014.

How would the cash flows between GMWF and AXA be changed? Again, be specific in timing and amounts.