Reference no: EM133114221

Suppose that the risk-free zero curve is flat at 4% per annum with continuous compounding and that defaults can occur at times 0.5 years and 1.5 years in a 2-year plain-vanilla credit default swap where the payments are made annually in arrears. Suppose that the recovery rate is 40%. The probabilities that the reference entity survives to the end of the first year and to the end of the second year are assumed to be 98.9% and 95%, respectively.

(a) What is the breakeven credit default swap spread?

(b) After the financial crisis, CDS contracts have become more standardized. If this CDS contract is standardized, this contract will be quoted as a standard spread of 100 basis points annually plus an up-front payment to the seller (from the buyer). The up-front payment is defined as the excess amount received by the seller from the CDS contract with the spread computed in part (a) over the one from the CDS contract with the spread of 100 basis points. Compute this up-front payment.