Upon landing a job with an investment bank, you are asked to evaluate a few CDS deals.
Question:
Upon landing a job with an investment bank, you are asked to evaluate a few CDS deals. The contemplated CDS has a 5-year tenure and calls for annual payments to be made at the end of each year. The reference identity's conditional probability of default during a year conditional on no earlier default is 3.5%. The estimated recovery rate is 45%. The LIBOR rate is 4.4%.
A) Assume that when default occurs, it occurs in the middle of the year. Please calculate the fair CDS spread. A 7-year CDS on the same reference identify was struck two years ago (with your firm being the protection seller) had a contract spread of 180bp for a principal amount of $350 million. What is the value of the CDS to firm at this point?
B) Assume that when default occurs, it occurs at the end of the year. Please calculate the fair CDS spread.
C) Compare the fair spreads from A) and B). Without doing calculations, please discuss the size of the CDS spread if the swap payments are made at the beginning of each year (for discussions here, assume defaults occur in the middle of the year).