Treasury Rate Corporate Rate Recovery 1.00% Default Rate 1.00% 3.00% Implied Default Rate 3.16% p*Default Payoff + (1-p) * No Default Payoff = Treasury 40.00% p*Default Payoff + No Default Payoff - p * No Default Payoff = Treasury Treasury - No Default Payoff = p * Default Payoff - p * No Default Payoff No Default Payoff - Treasury = p * No Default - p * Default Payoff Corp Bond (No Default Payoff - Treasury)/(No Default Payoff - Default Payoff) = p 100 Default No Default 40 103 Just Payments - No p adjusted p adjusted Treasury 100 Default No Default 0.01 101 Total 101.01 Contract should reflect: . An annual payment from the owner of the CDS contract A recovery rate of 60% A yield on the corporate of 4% A 1-year risk free rate of 0% Calculate an implied default rate? The Implied Default Rate G2 is at 6.82% 1 What happens to that default rate as: 1. Corporate yield falls to 3%. Why does this make sense? The Implied Default Rate will decrease to 4.65%. You're getting more money, and something has to give on the other side. 2. Risk free rate rises to 1%. Why does this make sense? 3. Recovery rate falls to 40%. Why does this make sense? Of these 3 assumptions, what do you think the most prone to estimation error? Why? As an investor seeking to have a proper margin of error, what should you do about this assumption? Treasury Rate Corporate Rate Recovery 1.00% Default Rate 1.00% 3.00% Implied Default Rate 3.16% p*Default Payoff + (1-p) * No Default Payoff = Treasury 40.00% p*Default Payoff + No Default Payoff - p * No Default Payoff = Treasury Treasury - No Default Payoff = p * Default Payoff - p * No Default Payoff No Default Payoff - Treasury = p * No Default - p * Default Payoff Corp Bond (No Default Payoff - Treasury)/(No Default Payoff - Default Payoff) = p 100 Default No Default 40 103 Just Payments - No p adjusted p adjusted Treasury 100 Default No Default 0.01 101 Total 101.01 Contract should reflect: . An annual payment from the owner of the CDS contract A recovery rate of 60% A yield on the corporate of 4% A 1-year risk free rate of 0% Calculate an implied default rate? The Implied Default Rate G2 is at 6.82% 1 What happens to that default rate as: 1. Corporate yield falls to 3%. Why does this make sense? The Implied Default Rate will decrease to 4.65%. You're getting more money, and something has to give on the other side. 2. Risk free rate rises to 1%. Why does this make sense? 3. Recovery rate falls to 40%. Why does this make sense? Of these 3 assumptions, what do you think the most prone to estimation error? Why? As an investor seeking to have a proper margin of error, what should you do about this assumption