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Bank A has exposure to USD 100 million of debt issued by company R. Bank A enters into a credit default swap transaction with bank B to hedge its debt exposure to company R. Bank B would fully compensate bank A if company R defaults in exchange for a premium.
1. Assume that the defaults of bank B and company R are independent and that their default probabilities are 0.5% and 3.6%, respectively. What is the probability that bank A will suffer a credit loss in its exposure to company R?
2. Now assume instead that bank B and company R default probabilities are still 0.5% and 3.6% but their default correlation is 0.25 (i.e., defaults are no longer independent). What is the probability that bank A will suffer a credit loss in its exposure to company R in this case?
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Another utilization of cash flow analysis is setting the bid price on a project.
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