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Study Session 13: Fixed Income: Topics in Fixed Income Analysis

Credit Default Swap

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I do not get the following:

1.Does trading at 50% of par mean that the bond is at default and this is the value the bond holder will recieve at default

2.Why would Deem can cash settle for $6 million [= (1 – 40%) × $10 million] on its CDS, does a $10mm CDS mean that the other party pay the difference between the $10mm and the $4mm?

3.In case of physical settlement, why would Deem deliver the bond, is not he the one that should receive the bond back in order to sell it?

Too low vs too high

Ran into a question that gave this in the problem set:

5% Annual VaR = [9.4% - (1.65 × 14.2%] = -14%

5% Daily VaR = [(0.0376% - (1.65 × 0.0568%)] = -0.056%

The question The calculated percentage value for daily VaR in Exhibit 1 is most likely:

A) correct given the assumptions and method described.
B) too high given the assumptions and method described.
C) too low given the assumptions and method described.

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Comments:

Payout Ratio & Recovery Rate

In Credit Default Swaps, the recovery rate is the rate that the protection buyer gets in case of default let’s say it is 40%. 

The payout ratio, is the amount that the protection seller pays. Based on the curriculum it is equivalent to 1-recovery rate, in that case it is equivalent to 60%.

My question is, should not the two be the same, as the amount paid by the seller is what the buyer gets??

Credit Rating

I do not get this question!

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Is not the total debt without defaulting $500,000, then why would I add the $200,000. As far as I understand, the $200,000 is the remaining debt that I will pay in case of default which is a part of the $500,000, so why would I add them together to get the value of the company’s total debt?

Value of interest rate call option

I’ve run into several questions that give you a binomial tree of interest rates and asks to calculate the interest rate call option value and provides a notion amount.

Let’s assume a 5% strike with a notion of $2M two year euro call option. The binomial tree is

4% 5.31% 8.3%

3.22% 5.04%

3.06%

Long CDS vs Short CDS

I am very confused with going Long CDS and going short CDS positions.

I have been doing some curriculum EOC questions and got incorrect answer. As I understand, protection buyers going Long on CDS position to transfer credit risk to protection seller, who going Short on CDS. However, the curriculum said something like this in its EOC solution: “shorting (buying protection) a long-term (20-year) CDX and going long (selling protection) a short-term (2-year) CDX”. Please correct my misunderstanding. I have spent hours on this.

Interest rate volatility

On pg. 137 underneath exhibit 11 CFAI uses the following formula: Ru=Rd×e√t. Why is the square root of t used? This was not part of the previous reading. Further, I don’t see Wiley use this formula at all.

Need help in understanding CDS Application in LBO

Hi,

When a company X make an unsolicited bid at a premium to acquire all the tradable shares of Y through issue of debt…say 5 n  10-Senior  unsecured bonds. How can one profit from a equity-versus credit trade involving X and Y.

1. Short Y shares and short X 10 year CDS

2. Long Y shares and short X 5 yr CDS

3. Long X shares and Long X 5 year CDS

Is it not Long Y shares and Long X 5yr CDS?? The new debt will increase X’s credit spread as a result the CDS price must go up. However, the answer is option 2. How is this possible?

Thanks.

Structural Models: What to know

In reading 38, LOS D, we are given an intimidating Black Scholes model to price company debt based on an option analogy.  However, the LOS says “Explain” not “Calculate”.  So does this mean we can just understand the intuition of of what is happening and be fine or do we need to memorize this formula?