CDS premiums

CFA Level III Derivatives
#1

Matilda Kim is a fixed income portfolio manager at Global Investment Ltd. (GIL). She is
responsible for managing the Income Opportunities Fund (IOF), an actively managed
fixed income fund with a mandate to invest in sovereign and corporate bonds and their derivatives.

Kim expects an economic slowdown that is not currently priced into fixed - income securities. She intends to profit from her view by trading a high-yield CDS index (CDX) contract, the details of which are displayed in Exhibit 2
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Kim buys $10,000,000 notional value of protection using the CDX contract. Kim’s view
turns out to be correct and after 12 months the CDS spread on the HY CDX contract
has doubled and the contract’s spread duration is 3.77.

The initial upfront premium on the CDX contract used by Kim to profit from her view
on an economic slowdown is closest to:
A) 1.5% paid to the IOF.
B) 7% paid to the IOF.
C) 7% paid by the IOF

Slowdown, so you buy protection on 5Y high-yield. And get a coupon higher than the spread, so, as a buyer, you get the difference between the coupon and the spread, multiplied by the duration, which is 7%.
I went for C: 7% paid by IOF, because Kim is the buyer, in my view. But they say:

HY CDS contracts have a fixed coupon standardized to 5%. The fair CDS spread for this contract is only 350 bps or 3.5%,; hence, the buyer of protection (which in this case is the IOF) is due an upfront premium payment equal to:
[(fixed coupon − CDS spread) × spread duration]
= [(5.00% – 3.50%) × 4.66] = 6.99%

Why is IOF the buyer, and not Kim?

Under the next question, which reads>
The total profit/loss from the CDX HY index trade is closest to:…
Under the explanation, they say: The fund is buying protection

I am confused… so the text clearly says, under Exhibit 2, that KIM buys the protection, but they go on that IOF does it… huh?

1 Like
#2

Please, anyone?

#3

Kim is managing IOF, so she will buy the protection for the IOF fund. What is more important is whether IOF receives/pays the upfront premium from/to the protection seller.

#4

To me, Kim IS IOF (meaning, on the same side of the transaction)… seller being an external party…

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#5

So yeah, as mentioned Kim is IOF, she runs the IOF fund and works at GIL.

Most important is she is buying protection as IOF, so she pays 5% when the market suggested spread is lower at 3.5%. Shes compensated for paying 5% on a lower spread by receiving an upfront of 7% as already mentioned as (5-3.5)*4.66.

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#6

Hey Mind the GAAP, I agree with you, but check this out:

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image1053×608 32.3 KB

So, again, they are saying IOF is the buyer. Which, in my view, makes no sense. Kim is the buyer, she needs to receive smth, because the spread is below the coupon.

#7

Kim = IOF = GIL

Its all the same person, Kim from IOF buys protection, pays 5% on market 3.5% and is due (5-3.5)*4.66 as a result.

#8

My correct answer was C, and they say B… idk, badly worded answer?

#9

Answer’s OK. Too much studying has started rotting your brain.

The IOF is a fund which Kim manages. If Kim buys something, it’s the same as the IOF buying it; if KIM sells something, it’s the same as the IOF selling it.

Here, Kim (i.e., the IOF) is buying protection (in the form of an index CDS) from BBCP (Big Bad CounterParty). The fair coupon rate (spread) is 3.5%, but the fixed coupon rate is 5.0%. Thus, Kim (i.e., the IOF) will pay too much in coupon payments for the CDS. To correct for that, BBCP will pay Kim (i.e., the IOF) an upfront payment of 6.99% (= (5.0% − 3.5%) × 4.66 years).

That’s all I know.