Assessment of CDS Investment for Company XYZ

Hard Credit Analysis And Valuation Credit Derivatives

In a recent analysis of credit derivatives, a financial analyst is evaluating a credit default swap (CDS) contract that provides protection on a corporate bond issued by Company XYZ. The CDS has a notional amount of $10 million, an annual premium of 200 basis points, and a maturity of 5 years. The analyst is trying to determine the expected credit risk associated with the bond.

Assuming that the probability of default for Company XYZ over the next 5 years is estimated at 10% and the recovery rate is 40%, the analyst calculates the expected loss and compares it against the present value of the premiums paid over the term of the CDS. What is the correct interpretation of these findings if the expected loss exceeds the present value of the premiums?

The CDS is a worthwhile investment since it offers significant protection against default.

The CDS may not be a worthwhile investment as the expected loss is greater than the premiums paid.

The CDS indicates a strong belief in Company XYZ's creditworthiness since the premium is low.

Hint

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