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Show that investing in a risky (credit-sensitive) bond is equivalent to investing in a risk-free bond...

Show that investing in a risky (credit-sensitive) bond is equivalent to investing in a risk-free bond plus selling a credit default swap

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Answer #1

In a credit default swap, the buyer pays a premium amount over the life of swap to protect itself from default of company.

the seller basically gets the premium amount , however has to take on the default risk of the company

Investing in a risky bond has a higher rate of interest than the risk free bond (Rf+ credit risk) , as it also takes on the credit risk

Similarly, investing in risk free bond+ selling a credit default swap will have same return (Rf + credit risk premium) and also has credit risk on it due to selling swap

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