Question

Bank A has a loan with firm X for $15.0 million. The loan is due in full at the end of year 3. To protect itself, the bank takes a credit default swap with LowRisk Insurance Company at a cost of 2.5% per year in fees. At the end of 3 years, firm X is able to pay back only $10.0 million in a negotiated settlement. Over the 3-year period, how much cash will the bank be able to recover for the loan?

a. $15.0 million

b. $14.875 million

c. $13.875 million

d. $10.0 million

Answer 1

• It is given in the question that to protect itself, the bank has taken a credit default swap with LowRisk Insurance Company at a cost of 2.5% per year in fees. Basically, it is a type of insurance against non-payment of debt.
• By using credit default swap, the bank has avoided the consequences of Firm "X"'s payment default by transferring risk to a Credit Default Swap dealer (seller) in exchange for a fee i.e. @2.5% per year.
• As the bank has taken Credit default swap with an insurance company, although Firm X has paid only $10 Million but Bank will be able to recover remaining $ 5 million through Credit default swap (CDS).
• So, the bank will be able to recover cash for the loan amounting of $15 Million
• Cost to bank will be = 2.5%*$15 Million*3 i.e. $1.125 Million
• Net cash flow =15-1.1.25=$13.875 Million (although loan recovery will be full amount i.e. $15 Million).