Question

.   Consider a CDS on Lehman Brothers default event. Given today’s market conditions you know that the present value of expected premium payments 6.0250*s, the present value of expected accrual payments is 0.0515*s and the present value of expected payoff is 0.1325. All measured per $1 of notional principal. You also know that Argo hedge fund bought this CDS on Lehman Brothers default from AIG one week ago with contractual rate of X basis points per year. Given this information the breakeven spread (i.e. the value of s) is _________ and today’s value of the CDS contract to AIG is positive if the value of s is _______ than X.

1. 222 basis points; greater
2. 218 basis points; smaller
3. 218 basis points; greater
4. 222 basis points; smaller
5. 84 basis points; greater

Answer 1

222 basis points; smaller

REASON :

Even though credit default swaps (CDS) are basically insurance policies against the default of a bond issuer, many investors used these securities to take a view on a particular credit event. The major bankruptcies in the fall of 2008 caught some investors in these contracts off-guard; after all, a major CDS event had not occurred since Delphi in November 2005.

The events of the fall of 2008 were a test of the systems that settle credit default swaps. This article will explore what happens to CDS holders when a company experiences a credit event, with the Lehman Brothers (LEHMQ) failure as an example.

As CDSs grew in popularity, they were used less as a hedging tool and more as a way to make a bet on certain credits. In fact, the amount of CDS contracts written outnumbers the cash bonds they are based on. It would be an operational nightmare if all CDS buyers of protection chose to physically settle the bonds. A more efficient way of settling CDS contracts needed to be considered.

To that end, cash settlement was introduced to more efficiently settle single-name CDS contracts when credit events occurred. Cash settlement better reflects the intent of the majority of participants in the single-name CDS market, as the instrument moved from a hedging tool to speculation, or credit-view, tool.