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Hedging using CDS
You would like to include corporate bonds into your existing portfolio. To hedge the potential default risk, you decide to purchase CSD (credit default swap) from Bank A. Suppose that the risk-free zero curve is flat at 6% per annum with continuous compounding and that defaults can occur half way through each year in a new five-year credit default swap. Suppose that the recovery rate is 35% and the default probabilities each year conditional on no earlier default is 3%. Assume payments are made annually.
a. What is CDS? Is it risky?
b. Estimate the credit default swap spread? (List your calculation process in tables).
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