$100M of 5 year AIG bonds are trading at 115 basis points over treasuries. A 5 year CDS on that same bond is being offered at 80 basis points over the swap curve. 1 year LIBOR is 3.25%, 5 year Treasury Rate is 4.35% and the 5 year swap rate is 4.80%. The float side of any interest rate swap is indexed to 1 year LIBOR and any borrowing or lending is also at LIBOR. Assume annual payments.

1. a)Is there a CDS mispricing? If so, outline any arbitrage opportunity by showing all the trading and hedging steps. Compute the annual cash flows at the end of year 1. Assume no defaults have occurred.
2. b)Assume that at the end of year 2, right after the coupon and CDS payments are made, the AIG bond defaults and its value goes to $20M. What are the annual cash flows, incomeand principal, at the end of year, if swaps rates haven't changed?