Solution to 1:
The investor should initially buy protection on the CDX HY Index and sell protection on the CDX IG Index. Current CDS prices are estimated by multiplying EffSpreadDurCDS by the spread difference from the standard rates of 1% and 5%, respectively:
CDX HY: 109.3 per $100 face value, or 1.093 (= 1 + (5.00% – 3.00%) × 4.65)
CDX IG: 99.066 per $100 face value, or 0.99066 (= 1 + (1.00% – 1.20%) × 4.67)
Since the investor is both buying HY protection at a premium to par (that is, agreeing to pay the 5% standard coupon while the underlying CDS spread is 3.00%) and selling IG protection at a discount from par (or agreeing to receive the standard 1.00% while the underlying index spread is 1.20%), the investor will receive an upfront payment for entering both positions as follows:
$1,023,400 = [$10,000,000 × (1.093 – 1)] + [$10,000,000 × (1 –0.99066)]
In one year, the return is measured by combining the net CDX coupon income or expense with the price appreciation assuming no spread change. As the investor is long CDX HY protection (i.e., pays the 5.00% standard HY coupon) and short CDX IG protection (or receives the standard 1.00% IG coupon), the net annual premium paid by the investor at year end is $400,000 (=$10,000,000 × (5.00% – 1.00%). The respective CDS prices in one year are as follows:
CDX HY: 107.52 per $100 face value, or 1.0752 (=1 + (2.00% × 3.76))
CDX IG: 99.244 per $100 face value, or 0.99244 (=1 + (−0.20% × 3.78))
To offset the existing CDX positions in one year, the investor would sell HY protection and buy IG protection. The investor is able to sell HY protection at a premium of 7.52, resulting in a $178,000 gain from the long CDX HY position over one year (1.093 – 1.0752) × $10,000,000). Since the investor must buy IG protection in one year at a lower discount to par of (1 – 0.99244), it has a $17,800 gain from the CDX IG position (= (0.99244 – 0.99066) × $10,000,000). Subtracting the $400,000 net coupon payment made by the investor results in a one-year loss from the strategy of $204,200 (= $178,000 + $17,800 – $400,000) with constant spreads.
Why are they showing gain If the investor buys Protection at 1.09 and sells it at 1.07? Please explain what I am missing here. Why they haven’t included the Upfront premium received in a gain?
The given example consists a number of mistakes. Rectified in the Errata.
Please check. chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/https://www.cfainstitute.org/-/media/documents/support/programs/cfa/2022-cfa-level-iii-errata.pdf
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