Question

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Explain what credit default swap is and how you could use CDS against government sovereign risk. (10 marks) (b) Based on the diagram below, answer the following questions Fixed rate:7% Company ABC Company XYZ Floating rate: LIBOR+0.5% © What is the swap? (5 marks) (ii) If the notional amount is $3,000,000 and the 1-year LIBOR rate is 6%, what is the net payment? Who is the payer? (10 marks)

Answer 1

A Credit Default Swap (CDS) is a Derivative Instrument and is generally used to protect against debt risk. These are similar to insurance. In a CDS agreement , one party takes the risk of debt default of a borrower against payment of regular premiums from the 2nd party which is the lender. So, the lenders , in order to protect themselves against Credit default of the borrower, undertakes a CDS contract with a third party. This can also be used to protect against government sovereign risk. In case lenders have loaned their money to government which is the borrower, to protect against the Sovereign risk , lenders can also undertake a CDS contract with a third party which assures them of repayment of their amount in case the government defaults.

b)

i) The diagram represents a fixed for floating swap contract where ABC pays periodic interest on a notional principal at a fixed rate of 7% to XYZ in exchange of floating rate of LIBOR+0.5% from XYZ. This swap agreement remains in force for a fixed amount of time and floating rate (LIBOR in this case) is generally decided at the beginning of each period.

ii) If the LIBOR rate is 6% then XYZ has to pay 6.5% to ABC and ABC has to pay 7% to XYZ on the notional principal of $3 million

Hence, on net basis, ABC has to pay 0.5% on notional principal of $ 3 million to XYZ.

So, ABC is the payer and the net payment is $3 ,000,00 *0.5% = $ 15,000