32-34.) You are asked to value a credit default swap on a bond with a $1,000,000...

32-34.) You are asked to value a credit default swap on a bond with a $1,000,000 face value. In the event of default, the bond is expected to have a recovery rate of 60%. The probability of default is 10%. You will be purchasing 3 years of protection. The Treasury STRIP rates are as follows: Maturity STRIP Rate 1 4% 2 6% 3 8% What is the cost of the credit default swap?

Solutions

Expert Solution

Assuming the defaults happen mid-way through the year and the STRIP rates are continuously compounded.

Let s be the CDS spread we are valuing here.

Now we know that,

PV of Expected Payments + PV of Accrual Payments = PV of Expected Payoffs

Therefore, CDS Spread (s) = $1000000 x 0.0421 = $42,100

jeff jeffy answered 1 year ago

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