On 1 January $20 \mathrm { X } 2$ , Deem Advisors Purchased A

question 14

Multiple Choice

On 1 January $20 \mathrm { X } 2$ , Deem Advisors purchased a $\$ 10$ million six-year senior unsecured bond issued by UNAB Corporation. Six months later (1 July 20X2) , concerned about the portfolio's credit exposure to UNAB, Doris Morrison, the chief investment officer at Deem Advisors, purchases a $\$ 10$ million CDS with a standardized coupon rate of $5 \%$ . The reference obligation of the CDS is the UNAB bond owned by Deem Advisors.

On 1 January 20X3, Morrison asks Bill Watt, a derivatives analyst, to assess the current credit quality of UNAB bonds and the value of Deem Advisors' CDS on UNAB debt. Watt gathers the following information on UNAB's debt issues currently trading in the market:

Bond 1: A two-year senior unsecured bond trading at $40 \%$ of par
Bond 2: A six-year senior unsecured bond trading at $50 \%$ of par
Bond 3: A six-year subordinated unsecured bond trading at $20 \%$ of par With respect to the credit quality of UNAB, Watt makes the following statement:
"There is severe near-term stress in the financial markets and UNAB's credit curve clearly reflects the difficult environment."

On 1 July 20X3, UNAB fails to make a scheduled interest payment on the outstanding subordinated unsecured obligation after a grace period; however, the company does not file for bankruptcy. Morrison asks Watt to determine if UNAB experienced a credit event and, if so, to recommend a settlement preference.

Kand Corporation

Morrison is considering purchasing a 10-year CDS on Kand Corporation debt to hedge its current portfolio position. She instructs Watt to determine if an upfront payment would be required and, if so, the amount of the premium. watt presents the information for the CdS
in exhibit 1.
$$\begin{array}{l}\text { EXHIBIT } 1 \text { Summary Data for 10-year CDS on Kand Corporation }\\\begin{array} { l l } \hline \text { Credit spread } & 700 \text { basis points } \\\text { Duration } & 7 \text { years } \\\text { Coupon rate } & 5 \% \\\hline\end{array}\end{array}$$ Morrison purchases the 10-year CdS on Kand Corporation debt. two months later the credit spread for Kand Corp. has increased by 200 basis points. Morrison asks watt to close out the firm's CdS position on Kand Corporation by entering into new offsetting contracts.
Tollunt Corporation deem advisors' chief credit analyst recently reported that tollunt Corporation's five-year bond is currently yielding 7% and a comparable CdS contract has a credit spread of 4.25%. Since libor is 2.5%, watt has recommended executing a basis trade to take advantage of the pricing of tollunt's bonds and CdS. The basis trade would consist of purchasing both the bond and the CdS contract.
-Should watt conclude that uNab experienced a credit event?

• A) Yes.
• B) No, because uNab did not file for bankruptcy.
• C) No, because the failure to pay occurred on a subordinated unsecured bond.

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Definitions:

Promises To Pay

Agreements or commitments by a debtor to pay a specific amount by a certain date to a creditor.

Direct Write-off Method

A method of accounting for bad debts that involves charging unpaid invoices directly to the expense account when they are determined to be uncollectible.

Allowance Method

An accounting technique used to estimate uncollectible accounts receivable and record them as an expense.

Bad Debts

Money owed to a company that is considered irrecoverable and is written off as a loss.