The ABC Bank enters into a credit default swap with XYZ Financial. The swap runs for 5 years and is based upon a term loan to LMN Corp. The size of the protection payment is 5% per year. Unfortunately, LMN goes bankrupt a year after when this swap agreement becomes effective. Even with a 75% recovery value on the underlying loan, XYZ has paid ABC $20 million for settlements. How much has ABC lent to LMN?

Question

Quizplus · Accepted Answer

Since XYZ pays ABC $20 million after a 75% recovery value on the underlying loan, we can calculate the total amount of the underlying loan by: 
$20 million = (1-0.75) x 5% x total loan amount x 4 years 
Simplifying, we get:
$20 million = 0.05 x total loan amount x 4 
Therefore, the total loan amount is:
Total loan amount = $20 million / (0.05 x 4) = $100 million 
Therefore, ABC lent $80 million to LMN Corp.

The ABC Bank Enters into a Credit Default Swap with XYZ