A credit default swap (CDS) is a contract in which the writer pays the owner an amount of money if a so-called reference entity (typically a corporation) defaults on its debt.

Consider an investor who owns 10m USD worth of Caterpillar debt. She wishes to ensure herself against possible default. If Caterpillar remains solvent, she will be repaid 10.25m USD (principal plus interest), while if it defaults, she will receive 40%* of her principal and no interest (4m USD). Now if she buys a CDS, she will receive 6m USD from her counter-party if Caterpillar defaults. How much is she willing to pay for the CDS? You may take the risk-free rate to be zero. Hint: think of this like a married put where 'u' means solvent and 'd' default.

*(this is called the recovery rate in CDS pricing)

0.24m USD

3.28m USD

0.08m USD