In the errata (the corrected answer) Q1, “The investor should initially buy protection on the CDX HY Index and sell protection on the CDX IG Index.”
The price change is like this:
CDX HY: 109.3 per $100 face value, or 1.093 (= 1 + (5.00% – 3.00% × 4.65))
CDX IG: 99.066 per $100 face value, or 0.99066 (= 1 + (1.00% – 1.20% × 4.67))
After a year, the price is like this:
CDX HY: 107.52 per $100 face value, or 1.0752 (=1 + (2.00% × 3.76))
CDX IG: 99.244 per $100 face value, or 0.99244 (=1 + (−0.20% × 3.78))
However, what I feel confused about is - since we BUY PROTECTION with CDX HY; why the gain from CDX HY is (1.093 – 1.0752) × $10,000,000), instead of the other way round? I thought you buy a protection at year 0 and after one year you sell it - if the price goes down, you suffer loss - but apparently it’s not the case here …
I didn’t think the errata was wrong. You buy credit protection with CDX HY at time zero. After one year you have to take the opposite position to unwind
My understanding is that if you buy credit protection, that means you ‘short’ the risk of default. Hence, when the price of CDS goes down, you actually gain.
I guess you can think of it this way - you initially sign a contract that you are going to be compensated a certain amount. Soon after, the CDS price goes down (ie. Credit spread widens, hence you are going to be compensated lower if you were to sign the contract afterwards), you are relieved knowing that you have signed a more advantageous contract rather than doing so after the credit event.
You can also refer to Example 22 of Reading 14 for related example.