You want to hedge against a potential default in your bond holdings. You have holdings of $10,000,000 and decide to enter into a CDS contract of the same value. Using the details below, derive the total profit/loss on the CDS contract. Assume a default occurs in year 3 and that no payment of premium is paid in that year. Draw the cash flow diagram for the contract:

CDS Contract

CDS Spread

2.5%

CDS Contract Value

$10,000,000

Bond Holdings

$10,000,000

Premium Frequency

Semi-Annual

Expected Default Rate

8%

Default Year

Year 3

Contract Tenor

5 Years

Following on fromQuestion 6, assume that no default occurs. Instead, the creditworthiness of the underlying instrument improves, such that the CDS spread (premium) on offer on an equivalent 5 year CDS contract is now 1.5%. Recompute the total profit/loss for the contract if you close the position early in the 3rd year. No diagram is needed.