Fixed Income - Credit Default Swap
Consider two zero coupon bonds with identical cash flows, maturity in one year, but different rating. Their prices are 99 and 102.57 respectively.
i) Price a CDS contract whose seller has the highest rating. Give an arbitrage strategy if the CDS price is smaller or bigger than the proposed value.
ii) Deal with bond prices only in order to estimate the risk neutral probability of default before one year.
iii) Compute the probability above by dealing with the CDS price. Check that both probabilities are identical. Why?