Company X invests in numerous fixed income instruments and has a large long position on bonds issued by ABC Bank. Given the ongoing uncertainty posed by Russia's invasion of Kuwait, the rise in the price of oil, the economic headwinds posed by this situation, and the threat of spillover effects into the global financial markets has started to creep into the system.  ABC Bank has significant exposure to Europe's major economies and is putting significant strain on the bank's liquidity position.  The chief investment officer of Company X is concerned about the risks that the deteriorating credit perception of banks can pose on his bond portfolio and on his ABC Bank holdings specifically.  He is looking at buying protection by entering into a five year credit default swap on his ABC Bank bonds.  The current default probabilities are at 25% while the recovery rate is at 45%. 

 

1. Assuming a risk-free rate of 1.50%, what would be the premium that Company X would pay if it wanted to enter into a long position on a credit default swap on its ABC Bank holdings?  If you were the chief investment officer would you enter into these credit default swaps?  Why or why not?
2. If you were a speculator and had a view that the tenuous geopolitical situation will push Europe into another recession and possibly a major crisis, how would you try to profit from this by using credit default swaps? Explain how you will formulate your position and explain how your bet will pay off if the worst case scenario occurs.  Turning the situation around, if you were at the worst stage of the crisis and you had a view that an ultimate resolution to the situation was coming within the next two years, how can you profit from this situation using credit default swaps?
3. After one year has passed, assume that the situation in Ukraine has stabilized and an increase in global oil output has made oil prices settle down to levels seen before the Russian invasion leading to significant improvements in economic growth rates. The prevailing default probabilities for ABC Bank bonds has decreased significantly to 8% with a recovery rate of 55%.  The risk-free rate has increased to 4.50%.  Calculate the mark-to-market valuation of the remaining term of the CDS contract Company X.  Are they in-the-money or out-of-the-money?  Should Company X keep its long position or should it get out of the CDS contract?  Why or why not?