Question

Suppose that: (a) The yield on a 5 -year risk-free bond is $7 \%$. (b) The yield on a 5-year corporate bond issued by company $\mathrm{X}$ is $9.5 \%$. (c) A 5-year credit default swap providing insurance against company $\mathrm{X}$ defaulting costs 150 basis points per year. What arbitrage opportunity is there in this situation? What arbitrage opportunity would there be if the credit default spread were 300 basis points instead of 150 basis points?

    Suppose that:
(a) The yield on a 5 -year risk-free bond is $7 \%$.
(b) The yield on a 5-year corporate bond issued by company $\mathrm{X}$ is $9.5 \%$.
(c) A 5-year credit default swap providing insurance against company $\mathrm{X}$ defaulting costs 150 basis points per year.
What arbitrage opportunity is there in this situation? What arbitrage opportunity would there be if the credit default spread were 300 basis points instead of 150 basis points?

Options, Futures, and Other Derivatives

John C. Hull 10th Edition

Chapter 25, Problem 27

Instant Answer

Step 1

The risk premium is the difference between the yield on the corporate bond and the risk-free bond. In this case, the risk premium is $9.5\% - 7\% = 2.5\%$. Now, let's consider the credit default swap (CDS) cost. The CDS cost is 150 basis points per year, which is Show more…

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Suppose that: (a) The yield on a 5 -year risk-free bond is $7 \%$. (b) The yield on a 5-year corporate bond issued by company $\mathrm{X}$ is $9.5 \%$. (c) A 5-year credit default swap providing insurance against company $\mathrm{X}$ defaulting costs 150 basis points per year. What arbitrage opportunity is there in this situation? What arbitrage opportunity would there be if the credit default spread were 300 basis points instead of 150 basis points?

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