CFA Level II ExamFixed IncomeMedium
A bond analyst is evaluating a credit default swap (CDS) on a corporate bond. The bond has a notional principal of $10 million, a maturity of 5 years, and a CDS spread of 150 basis points. The recovery rate is assumed to be 40%. What is the approximate expected loss on this bond if a default occurs?
- A$1.5 million
- B$4.0 million
- C$15.0 million
- D$6.0 million
Show answer & explanationAnswer & explanation
Correct answer: D. $6.0 million
The expected loss given default (LGD) is calculated as (1 - Recovery Rate) × Notional Principal. In this case, (1 - 0.40) × $10,000,000 = 0.60 × $10,000,000 = $6,000,000. The CDS spread and maturity are relevant for pricing the CDS, but not for calculating the expected loss if a default occurs.
Why the other options are wrong
- A. This is the annual premium (CDS spread * notional), not the total expected loss in case of default.
- B. This represents the recovery amount (Recovery Rate * Notional Principal), not the loss.
- C. This amount is significantly inflated and does not correspond to a standard calculation in this context.
Expected Loss Given Default
Expected Loss Given Default (LGD) represents the proportion of a bond's principal that an investor expects to lose if the issuer defaults. It is a key component in credit risk analysis.
- LGD = (1 - Recovery Rate) × Exposure at Default (Notional Principal).
- The recovery rate is the percentage of the principal amount that can be recovered after a default.
- It is distinct from the probability of default and the CDS spread, though related.
Memory trick: Loss is (1 - Recovery) times Notional's story.