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3. Suppose that the risk-free zero curve is flat at 7% per annum with continuous compounding and that defaults can occur halfway through each year
3. Suppose that the risk-free zero curve is flat at 7% per annum with continuous compounding and that defaults can occur halfway through each year in a new 2-year credit default swap. Suppose that the recovery rate is 30% and the default probabilities each year conditional on no earlier default is 3%. (a) Estimate the credit default swap spread. Assume payments are made annually. (b) What is the value of the swap per dollar of notional principal to the protection buyer if the credit default swap spread is 150 basis points? (c) What is the credit default swap spread if it is a binary CDS? (d) Verify that, if the CDS spread is 100 basis points, the probability of default in a year (conditional on no earlier default) must be 1.3703%
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