Plot the P&L distribution for the seller in both scenarios. Comment on the outcome

Job Posted: 30.11.2021 12:33:03

Constant hazard rate and expected recovery rate of 55% on its senior debt
Libor curve is 1 compounded annually
Appropriate CD’s spread of 11%
Important to note market practice is to quote CD’s to very high risk entities on a point upfront basis

. You read the following in a CDS manual published by an investment bank:
Points Upfront: For highly distressed credits, trading on spread can become problematic
because the P&L distribution of buying or selling protection becomes much wider than
the P&L distribution of buying or selling the underlying reference entity (even though the
expected values are the same). In order to keep the distributions more in line, when
spreads get very wide, the market convention is for the protection seller to require a
500bps premium plus an additional upfront payment from the protection buyer.
i. Plot the P&L distribution for the seller in both scenarios. Comment on the
investment bank’s thesis.

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