Consider a five year credit default swap with notional value $1 billion on a bond with risk neutral probability of default = 4% and loss given default = 30%. In the event of default, the protection seller must pay to the protection buy an amount equal to the notional value multiplied times LGD. Assume that all cash flows occur at the end of a year.
Estimate the CDS spread (that is, the annual percent of face
value to be paid by protection buyer to protection seller).
Suppose that one year later a bad recession begins and the risk
neutral probability of default rises to 10%, What is the value of
this CDS to the protection buyer?
Extra detail is also provided with proper explanation.
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