Bank A is able to raise funds at Libor. Bank B does so at Libor + 30 bps. Bank A buys a reference credit risky asset returning Libor + 70 bps, and then, A and B contract with each other on a credit swap (CDS) where A buys protection on the reference asset from B for $y$ bps. What range of basis points $y$ would be acceptable to both parties in the contract?

Question

Quizplus · Accepted Answer

For Bank A, the cost of funds is Libor, and it earns Libor + 70 bps on the reference asset. To ensure a profit, A would want to pay less than 70 bps for the CDS. For Bank B, the cost of funds is Libor + 30 bps. To make a profit from the CDS, B would need to receive more than 30 bps. Therefore, both parties would find a range of $40 < y < 70$ bps acceptable.

Bank a Is Able to Raise Funds at Libor yyy Bps What Range of Basis Points

Bank a Is Able to Raise Funds at Libor $y$ Bps What Range of Basis Points