Big City Bank enters into a credit default swap with LifeCo, a highly rated insurance company. The notional amount of the swap is $20 million. The 5-year swap is based on a 5-year loan to ABC Corp. The size of the protection payment is 2.78% per year.
a. How much does Big City Bank pay LifeCo for each year the swap is in place?
b. If ABC does not suffer a credit event, how much does LifeCo pay Big City Bank over the 5-year life of the swap?
c. Assume that ABC goes bankrupt before the swap matures and that the recovery value on the underlying loan is 45%. How much does LifeCo owe Big City Bank?