Question 1

Consider a five-year Credit Default Swap (CDS) on Company AAs five-year bond security with a current yield of 8% per annum. The probability of default on Company AAs bond security, given its risk profile, is 3.5% per annum. The continuous compounding risk-free rate is 5.5% per annum. The percentage of the principal that will be recovered in the case of a default is estimated to be 45%.

1.1 What type of CDS is given in the scenario above? (1)

1.2 Calculate the probabilities of survival and the present value of expected payments for Year 1 up to Year 5. (5)

1.3 In addition to the information in the scenario, assume that the CDS spread is 4% per annum, paid quarterly, on a notional amount of R80 million, and that investors can borrow in the repo market at 5.5%.

1. 1. 1.3.1 Determine the quarterly payment on the CDS. (1)
2. 1. 1.3.2 Describe arbitrage opportunities, if any, that an astute investor should make use of. (3)