Protective short example

This is a question from the credit default swap from the CFA book. I don’t get the answer! [removed by moderator]


I would understand that the protection buyer would benefit in case he had purchased it earlier than the two months where he has already paid the upfront premium and will benefit from any increase later on. But if the buyer shorts at the time of the increase of the credit spread, he will pay the difference in the credit spread as an upfront premium.

Hard to read the question cause of the format and the choices arent there…

But I think whats going on: To buy protection, deem was short on the CDS. The spread was 700bps while the coupon was 5%, so the difference is 200bps. So Deem had to put an outlay of 2% (times the duration). The premium makes it an even trade for the risk.

Now the spread increased by another 200 bps, which is 900 bps. Taking a reverse position (going long) would now give 4% to Deem (9-5). Since Deem paid 2% originally, he now net’s 2% (4-2).

Generally terms… 2 months pass so the duration is a little less as well. You follow the general idea. It looks like the answer choices are likely general terms and not specific terms.