Credit Default Swaps

Question 1

Expected loss

Answer 1

=hazard rate * loss given default

Hazard rate: probability of default given that default has not already occurred

Question 2

Factors that influence the pricing of CDA (i.e., CDS spread)

Answer 2

Probability of default, loss given default, coupon rate on the swap

Question 3

Upfront premium on a CDS

Answer 3

Upfront payment (by protection buyer) = PV(protection leg) - PV(premium leg)
Or approximately:
Upfront premium = (CDS spread - CDS coupon) * duration

Question 4

Profit for protection buyer (change in value for a CDS after inception)

Answer 4

= change in spread * duration * notional principal

Profit for protection buyer (%) = change in spread (%) * duration

Question 5

Naked CDS

Answer 5

Investor with no exposure to the underlying purchases protection in the CDS market

Question 6

Basis trade

Answer 6

An attempt to exploit the difference in credit spreads between bond markets and the CDS market. Rely on the idea that such mispricings will be temporary and that disparity should eventually disappear after it is recognized