Question 3 Credit Derivatives (10 marks) Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year credit default swap with semi-annual payments. Suppose that the recovery rate is 20% in the event of default and the unconditional probabilities of default for each half- year period (as seen at time zero) are 1% at times 0.25 years and 0.75 years, and 1.5% at times 1.25 years and 1.75 years. Required: Use the Hull and White model to calculate the fair CDS annual premium assuming that defaults only occur at mid- period at which time accrual fee is payable and notional principal for the contract is $1. You are expected to prepare four tables similar to the ones in the lecture slides. Question 3 Credit Derivatives (10 marks) Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year credit default swap with semi-annual payments. Suppose that the recovery rate is 20% in the event of default and the unconditional probabilities of default for each half- year period (as seen at time zero) are 1% at times 0.25 years and 0.75 years, and 1.5% at times 1.25 years and 1.75 years. Required: Use the Hull and White model to calculate the fair CDS annual premium assuming that defaults only occur at mid- period at which time accrual fee is payable and notional principal for the contract is $1. You are expected to prepare four tables similar to the ones in the lecture slides