Question

January 1st, 2001 Lone pine capital has purchased a credit default swap on $20 million worth of Spanish debt from Goldman Sachs (i.e., Goldman Sachs is the seller of the CDS and must deliver payment upon a Spanish default). The contract requires that Lone Pine pays 400 basis points per year each year for 5 years on December 31st (i.e, the first annual payment is due December 31st 2001). On June 31, 2002, six months after Lone Pine’s last payment to Goldman, the Spanish government defaults. The Spanish debt is now worth $.75 per $1.00. How much must Goldman Sach’s pay Lone Pine Capital?

The answer is $4,600,000. Please show how to get there.

Answer 1

Original Debt Value = $ 20 million, Promised Interest Rate on CDS = 400 basis points or 4 % (CDS Interest is usually calculated on the face value of the debt which is $ 20 million in this case)

Default Date: 31st June 2002 and Last payment date before default: 31st Dec 2001

Interest Accrued during 6-Months = 0.04 x 0.5 x 20000000 = $ 400000

Debt Value Upon Default = $ 0.75 per $ 1 = 0.75 x 20000000 = $ 15000000

Therefore, Amount Owed by Goldman to Lone Capital = Original Face Value of Borrowing - Default Value of Borrowing - Accrued Interest = 20000000 - 15000000 - 400000 = $ 4600000