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Buyer of protection sells bonds issued by the

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buyer of protection sells bonds issued by the reference entity for their face value. Bonds with a total facevalue equal to the notional principal can be sold. In the event of a default when there is cash settlement,a calculation agent or an auction determines the value of the cheapest-to-deliver bonds issued by thereference entity a specified number of days after the default event. The cash payoff is then based on theexcess of the face value of these bonds over the estimated value.16.7 Explain the difference between risk-neutral and real-world default probabilities.Risk-neutral defaultprobabilities are backed out from credit default swaps, asset swaps or bond prices. Real-world defaultprobabilities are calculated from historical data. Risk-neutral default probabilities should be used forvaluation. Real-world default probabilities should be used for scenario analysis and credit VaRcalculations.
16.9 The spread between the yield on a three-year corporate bond and the yield on a similar risk freebond is 50 basis points. The recovery rate is 30%. Estimate the average hazard rate per year over thethree-year period.16.10 The spread between the yield on a five-year bond issued by a company and the yield on a similarrisk-free bond is 80 basis points. Assuming a recovery rate of 40%, estimate the average hazard rate per
year over the five-year period. If the spread is 70 basis points for a three-year bond, what do your resultsindicate about the average hazard rate in years 4 and 5?
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Term
Spring
Professor
Yung
Tags
Basel II, Capital requirement, Credit default swap, Expected shortfall, long run average variance

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