Assume 1-year LIBOR is 1.00%, and a risky bond has a rate of LIBOR + 5% [This means that the risk-free bond has a rate of LIBOR (or 1%)]

Assume interest is paid/received quarterly.

Each bond is priced at par of $100 and has 1 year to maturity.

Assume that an investor buys the risky bond and short sells the risk free bond.

Assuming no defaults in the underlying bonds:

I. replicates a short position in a CDS

II. replicates a long position in a CDS

III. Results in a net positive cash flow of $1.25 per quarter for the investor

IV. Results in a net negative cash flow of $1.25 per quarter for the investor

Ans:

a) I and IV

b) II and IV

c) II and III

d) I and III