3. (a) What is meant by the term credit risk? What are the key inputs...
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3. (a) What is meant by the term credit risk? What are the key inputs into, and how do they impact, a model that attempts to quantify credit risk? (b) Describe how a Collateralized Debt Obligation (CDO) is formed and how it distributes income to its investors? What is the risk borne by the investor? (c) A 2-year Credit Default Swap (CDS) with a notional principal of 80 million and a credit default spread of 140 basis points is initiated today. The reference entity is a firm called NCM. Premium payments are made semi-annually in arrears. (i) What is the purpose of a CDS? (ii) Describe the risk facing the writer of the CDS (the holder of the short side of the contract). (iii) Show the cashflows between the purchaser and seller of the contract written on NCM if the firm does not default during the life of the contract. (iv) Show the cashflows between the purchaser and the seller of the contract written on NCM if the firm defaults after 1 year and 10 months.
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