A lobby group in HK advocates the deregulation on CDS contracts. They make the following statement CDS contracts facilitate firm borrowing because investors in the corporate bond market can purchase CDS contract and face no default risk, and thus firms will face lower financing cost. The HK monetary authority asks you to help them evaluate the argument. For simplicity, ignore the underlying counterparty risk in all your analysis. Suppose the risk free rate is 2%, the market return is 7%.

a) Suppose a Firm XYZ issues 1 million HKD face value 1 year zero coupon bond and the market estimates that with 20% probability XYZ will default. Upon default, the creditor can choose either to liquidate the firm or to accept a restructure plan. The liquidation plan will leave the creditor 100K HKD while the restructure plan will give the creditor 500K HKD. Suppose the beta for the XYZ corporate bond is 1.6, how much money can firm XYZ borrow with the 1 million zero coupon bond? (4 points)

b) Now suppose the Creditor purchases 900K HKD CDS contracts on XYZ corporate bond. The contract gives the investor 900K HKD if XYZ is liquidated. Suppose the beta for the XYZ corporate bond is 1.6. What is the price for this CDS contract? (5 points)

c) Compare your analysis in question b) and c), is the analysis supportive, against or irrelevant to the lobby groups statement? Explain. (5 points)

d) Now the lobby group pays you a big amount of money to work for them (Money changes people). Besides your original analysis, name 2 factors that may favor the lobby groups argument (factors that not included or ignored in your original analysis). Explain. (6 points)