Impact on CDS Position Following Default

Very Hard Credit Analysis And Valuation Credit Derivatives

In the context of credit derivatives, a financial institution enters into a credit default swap (CDS) where it sells protection on a corporate bond issued by Company XYZ. The upfront premium agreed upon is 150 basis points (bps) but is partially financed by the institution's higher exposure to a credit risk from Company XYZ, which has shown deteriorating credit metrics recently.

Two years later, the corporate bond is downgraded by two notches, prompting the financial institution to evaluate its CDS position. The CDS reference obligation has a recovery rate of 40% in the event of a default. Determine the impact on the institution's position should a default occur, considering the market value of the reference asset and cash flows arising from the CDS arrangement.

The institution will incur a total loss equal to the CDS premium paid plus the market value of the bonds minus the recovery rate.

The institution will receive the CDS payout, which is the market value of the corporate bond minus the recovery rate, resulting in a profit if the premium paid is lower than this amount.

The institution will have no loss as it will recoup its premium by claiming the recovery rate in the event of default.

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