One of Royal Bank of Canada's (RBC) clients, Wellington Financial Management, has asked for a new $50 million loan. However, if RBC grants it, this loan is exposure to Wellington is too large, i.e. the concentration risk exceeds RBC's internal guidelines. Now, RBC has approached JP Morgan to see if credit default swap between JP Morgan and itself can be established, which would mitigate the extra credit risk for RBC from the new loan. 

 

a.  What is a credit default swap? How does it work? 

b.  How does the role of interest rate swap differ from that of credit swap in terms of controlling risk?  

c.   Describe how you might do this using a five-year Index CDX if you wish to profit if the credit worsens