MGM 675 par bond is rated AA with maturity of 5 years A deal

MGM 6.75% par bond is rated AA with maturity of 5 years. A dealer has quoted a 5 year credit default swap on this bond at 115/140. XYZ has $10 million U.S Treasury bond with a yield of 4.5 percent and wishes to replicate MGM bond by selling 5 year protection on MGM. XYZ is expected to earn yield of

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Solution

Greetings,

MGM Bond can be replicated by holding treasury bond and selling CDS on MGM bond. Selling CDS on a risky bond implies that we will lose if the credit quality of MGM gets deteriorated. So treasury bond lacks this risk, hence to manufacture Risky bond synthetically from treasury bond, we need to sell CDS on risky bond.

Holding treasury bond will give us return = 4.5%

Selling CDS would give us 1.15% (bid rate). So total return would be 5.65%