Compute the cash flows two years from today

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Reference no: EM132190040

Problem - Consider a zero-coupon bond maturing in 2 years with a face value of $1,000 and a yield to maturity of 6%. Assume the loss-given-default is 60%, and that default can only happen in exactly two years. There is a credit default swap available for this bond with spread 4.4%.

(a) For both a bondholder and a (different) CDS buyer (with notional value $1,000), compute the cash flows two years from today in case the bond defaults, and in case it doesn't. Include only cash flows two years from today, and not the quarterly payments the CDS buyer makes to the CDS seller or the up-front cost of the bond. Note that CDS cash flows include only cash flows from the CDS and do NOT include cash flows from the bond itself.

Scenario	Bond cash flow	CDS cash flow
Default
No default

(b) How big are the CDS payments if they are made quarterly?

(c) Now consider a portfolio including a bond with face value S1,000 and a CDS with notional value S1,000. Compute the cash flows two years from today in the case the bond defaults, and in the case it doesn't. Include only cash flows two years from today, and not the quarterly payments the CDS buyer makes to the CDS seller or the up-front cost of the bond.

Scenario	Portfolio cash flow
Default
No default

(d) Assuming the CAPM is true, the risk-free rate is 0.3% per quarter, the market risk premium is 1.5% per quarter, and the bond's beta is 0.25, what must the per-quarter expected return be of the portfolio described in part (b)? Hint: Think about the beta of the portfolio without trying to compute the beta of the CDS.

Reference no: EM132190040

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