Due M 8/2018 Finance 421 Problem 5: Credit default swaps (4 points) Consider a zero-coupon bond maturing in 2 years with a face value of S1,000 and a yield to matunty of 6%. Assume the loss-givera-default is %, and that default can only happen in exactly two years. There is a credit default swap available for this bond with spread 4.4%. (a) For both a bondholder and a (different) CDS buyer (with notional vaue $1,000), compute the cash flows two years from today in case the bond defaults, and in case it doesn't. Include only cash lows two years from today, and not the quarterly payments the CDS buyer makans to the CDS seller or the up-front cost of the bond. Note that CDS cash Hows include only cash flows from the CDS and do NOT inchade cash flows from the bond itself. Scenario Bond cash floW CDS cash flom Default No defaul (b) How big are the CDS payments if they are made quarterly? Quarterly Payments:- (c) Now consider a portfolio inclading a bond with face value $1,000 and a CDS with notional value $1,000. Compute the cash lows two years from today in the case the bond defaults, and in the case it doesn't Inchade only cash flows two years from today, and not the quarterly payments the CDS buyer makes to the CDS seller or the up-front cost of the bond Scenario Delault No defaiult Portfobo c (d) Assuming the CAPM is true, the risk-free rate is 0.3% per quarter, the market risk premium is 1.5% per quarter, and the bond's beta is 0.25, what must the per-quarter expected return be of the portfolio described in part (b)? Hint Think about the beta of the portfolio without trying to compute the beta of the CDS Portfolio expected return