5. Credit default swaps (intermediate). Mellon Bank sold a credit default swap to MetLife for the protection of 7-year US$375 million mortgage-backed securities requiring a semiannual payment of 65 basis points. In case of default, settlement is to be made in cash.

a. Default occurs on the anniversary of the seventh semiannual payment, at which point it is estimated that the reference bond value has slumped to 35 cents on the dollar; show the cash-flow payments and their timing for Mellon Bank.

b. What was/were the risk(s) faced by MetLife when it purchased the CDS from Mellon Bank? How can it protect itself against such risk(s)?

c. What does it mean for CDSs to be traded over-the-counter?Would you recommend that CDSs be traded on an organized exchange as currency or interest rate futures are?