Consider a Two-Year, Annual Pay CDS Contract, Where Premiums Are

question 8

Multiple Choice

Consider a two-year, annual pay CDS contract, where premiums are paid at the end of the year and if default occurs, it is also assumed to happen at the end of the year (but immediately after the premium payment) . Each year there is a 5% risk-neutral probability of the firm defaulting. In default, recovery is 50% (recovery of par, RP) . Assume that interest rates are zero. The fair price of this CDS is a spread of

• A) 200 bps
• B) 225 bps
• C) 250 bps
• D) 275 bps

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Definitions:

Cognitive Dissonance

The mental discomfort experienced by a person who holds two or more contradictory beliefs, ideas, or values at the same time, leading to an alteration in one of the attitudes, beliefs, or behaviors to reduce the discomfort and restore balance.

Competitive Inertia

A situation where a company continues with its current strategies because it has historically been successful, even when those strategies become less effective.

Affect

A term referring to the experience of feeling or emotion in psychology.

ABC Model

A framework in cognitive behavioral therapy that outlines the relationship between an activating event, beliefs, and consequences.