Question

4. A hedge fund bought a CDS contract from AIG to protect its position on Apple bonds. The par value of Apple bonds owned by this hedge fund is $ 10 million. The notional amount of the CDS contract is also $10 million. The bond’s maturity is five years, coupon is paid quarterly. The CDS contract also has five years maturity, and swap premium is paid quarterly. The swap premium is 1%. The coupon rate of Apple bond is 2%. The day count convention for the Apple bond and the CDS premium is actual/360. Today is January 1, 2016 (these two securities are just issued).

a.What are the cash flows for 2016 if Apple does not default until maturity? (15points)

b.What are the cash flows for 2016 if Apple defaults at September 29, 2016? Assuming physical settlement for the CDScontract. (15points)

Answer 1

Ans.a) The cash flow for 2016 if the apple does not default will be paid out in 4 quarterly installments for 5 years until maturity

Bond yield is 2% and all are quaterly in nature $ 10 million*0.02=0.2 million so every quarter the cash flow will be 0.2 million which will be paid out at every quarter that will be april 2016, july 2016, nov 2016 and so on

Ans.b)

In case of Apple defaults on Sept 2016

Till sept 2016, the hedge fund would be paying out the equal installement of 0.1 million dollar of CDS till every quarter as the notional amount used is same as the bond price

Hedge fund will receive the amount of $ 0.1 million from the CDS seller and would cease to payout the quaterly CDS Premium payment in the near future