Exam 11: Credit Default Swaps

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -The curve trade that would best capitalize on Chan's view of the uS credit curve is to:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -following the Maxx restructuring, the CdX hY notional will be closest to:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -to satisfy the compliance requirements referenced by Chan, the fund is most likely required to:

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. EXHIBIT 1 Summary Data for 10-year CDS on Kand Corporation Credit spread 700 basis points Duration 7 years Coupon rate 5\% 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. -if uNab experienced a credit event on 1 July, watt should recommend that deem advisors:

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. EXHIBIT 1 Summary Data for 10-year CDS on Kand Corporation Credit spread 700 basis points Duration 7 years Coupon rate 5\% 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. -based on exhibit 1, the upfront premium as a percent of the notional for the CdS protec- tion on Kand Corp. would be closest to:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -The hypothetical orion trade generated an approximate:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -which type of CdS should Chan recommend to Smith?

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. EXHIBIT 1 Summary Data for 10-year CDS on Kand Corporation Credit spread 700 basis points Duration 7 years Coupon rate 5\% 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. -according to watt's statement, the shape of uNab's credit curve is most likely:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -to close the position on the hypothetical orion trade, the fund:

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. EXHIBIT 1 Summary Data for 10-year CDS on Kand Corporation Credit spread 700 basis points Duration 7 years Coupon rate 5\% 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. -based on basis trade for tollunt Corporation, if convergence occurs in the bond and CdS markets, the trade will capture a profit closest to:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -based on the three economic outlook statements, a profitable long/short trade would be to:

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. EXHIBIT 1 Summary Data for 10-year CDS on Kand Corporation Credit spread 700 basis points Duration 7 years Coupon rate 5\% 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. -if deem advisors enters into a new offsetting contract two months after purchasing the CdS protection on Kand Corporation, this action will most likely result in:

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -a profitable equity-versus-credit trade involving delta and Zega is to:

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. EXHIBIT 1 Summary Data for 10-year CDS on Kand Corporation Credit spread 700 basis points Duration 7 years Coupon rate 5\% 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?

The following information relates to Questions John Smith, a fixed-income portfolio manager at a €10 billion sovereign wealth fund(Swf), meets with Sofia Chan, a derivatives strategist with Shire Gate Securities (SGS),to discuss investment opportunities for the fund. Chan notes that SGS adheres to iSda(international Swaps and derivatives association) protocols for credit default swap (CdS)transactions and that any contract must conform to iSda specifications. before the fund can engage in trading CdS products with SGS, the fund must satisfy compliance requirements. Smith explains to Chan that fixed-income derivatives strategies are being contemplated for both hedging and trading purposes. Given the size and diversified nature of the fund, Smith asks Chan to recommend a type of CdS that would allow the Swf to simultaneously fully hedge multiple fixed-income exposures. Next, Smith asks Chan to assess the impact on derivative products of recent events affect-ing Maxx Corporation, a uS company. The Swf holds an unsecured debt instrument issued by Maxx. Chan says she is very familiar with Maxx because many of its unsecured debt obliga-tions are commonly included in broad baskets of bonds used for hedging purposes. SGS recently sold €400 million of protection on the on-the-run CdX high yield (hY) index that includes aMaxx bond; the index contains 100 entities. Chan reports that creditors met with company executives to impose a restructuring on Maxx bonds; as a result,all outstanding principal obligations will be reduced by 30%.Smith and Chan discuss opportunities to add trading profits to the Swf. Smith asks Chan to determine the probability of default associated with a five-year investment-grade bond issued by orion industrial. Selected data on the orion industrial bond are presented in exhibit 1.eXhibit 1 Selected data on orion industrial five-Year bond Year Hazard Rate 1 0.22\% 2 0.35\% 3 0.50\% 4 0.65\% 5 0.80\% Chan explains that a single-name CdS can also be used to add profit to the fund over time. Chan describes a hypothetical trade in which the fund sells £6 million of five-year CdS protection on orion, where the CdS contract has a duration of 3.9 years. Chan assumes that the fund closes the position six months later, after orion's credit spread narrowed from 150 bps to 100 bps. Chan discusses the mechanics of a long/short trade. in order to structure a number of potential trades, Chan and Smith exchange their respective views on individual companies and global economies. Chan and Smith agree on the following outlooks. Outlook 1: italy's economy will weaken. Outlook 2: The uS economy will strengthen relative to that of Canada. Outlook 3: The credit quality of electric car manufacturers will improve relative to that of traditional car manufacturers. Chan believes uS macroeconomic data are improving and that the general economy will strengthen in the short term. Chan suggests that a curve trade could be used by the fund to capitalize on her short-term view of a steepening of the uS credit curve.another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that delta Corporation may make an unsolicited bid at a premium to the market price for all publicly traded shares of Zega, inc. Zega's market cap-italization and capital structure are comparable to delta's; both firms are highly levered. it is anticipated that delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio. -based on exhibit 1, the probability of orion defaulting on the bond during the first three years is closest to: