Example: Suppose a five-year default free note pays LIBOR-10 basis points, and the five-year debt issued by XYZ Corporation pays LIBOR+85 basis points.
A New York Bank has $125 million exposure to XYZ note.
a. What is the cost of 5-year default insurance if the financing rate for the above bond in the repo market is equal to LIBOR?
b. Suppose the cost of default insurance in the above example in the OTC market is equal to 110 basis points. What course of action swap dealer can take to earn arbitrage profit assuming $125 million exposure to the above bond? How much is the arbitrage profit?
c. Suppose the cost of default insurance in the above example in the OTC market is equal to 75 basis points. What course of action swap dealer can take to earn arbitrage profit assuming $125 million exposure to the above bond? How much is the arbitrage profit?