Problem 3

Consider a zero-coupon bond maturing in 2 years with a face value of $1000 and a yield to maturity of 2%. Assume the recovery rate is 40%, and that default can only happen exactly at the end of the 2-year period. There is a credit default swap (CDS) available for this bond, and the premium is 0.8&. (a) For both a bondholder and a CDS buyer (with notional value $1000), compute the cash ows two years from today in the case where the bond defaults and the case where it doesnt. Include only cash ows two years from today, and not the quarterly payments the CDS buyer makes to the CDS seller or the up-front cost of the bond.

Scenario	Bond Cash Flow	CDS Cash Flow
Default
No Default

b) Now consider a portfolio consisting of a bond with face value $1000 and a CDS with notional value $1000. Compute the cash ows two years from today in the case the bond defaults, and in the case it doesnt. Include only cash ows two years from today, and not the quarterly payments the CDS buyer makes to the CDS seller or the up-front cos of the bond.

Scenario	Portfolio Cash Flow
Default
No Default