In this workout, we're looking at a CDS contract where there actually is a credit event. Alpha buys a two-year CDs from Beta on a notional amount of 100 on the three-year bonds issued by Charlie. The CDS is an annual premium of 105 basis points and cash settlements. There is a credit event on Charlie's bonds just before the end of the second year and the bonds become valueless. This is, of course, an extreme scenario here that Charlie's bonds will become totally valueless. What will be the net cash flows over the CDS term for Alpha, assuming that Beta pays out on the CDS? Well, we know that the number of years here, the duration is two, we know that the premium is 105 basis points, and we know that the notional is 100.

So the total premium paid out here by Alpha, of course, will be two years times 1.05% times the 100 in the notional.

So Alpha will pay out a total of 2.1.

However, of course, there is now a credit event, and Alpha has bought protection on this credit. So now they're gonna be paid out under the CDS contract. The notional in the CDS contract was 100, and these bonds ended up being totally valueless, so we're gonna put in a remaining value of bonds there at zero. So of course, therefore the total CDS payment received will be that entire 100. So the net cash flows here, of course, for Alpha will be the 100 they received minus the 2.1 that they paid out, so a total of 97.9. So here the insurance policy of the CDS really paid out.

The second example describes exactly the same trade, two year CDS, 100 notional on Charlie, 105 basis points, et cetera, et cetera. There is a credit event in this workout, too, but Charlie's bonds turn out to be worth 40% of the notional amount, so there is recovery here, which is a more realistic scenario, really. What would be the net cash flows over the CDS term for Alpha assuming that Beta pays out on the CDS? Well, of course, it's a two-year trades deal. The premium per annum was 1.05%. The notional was 100. And therefore, of course, the total premium paid out by Alpha will be the annual premium times the number of years times the notional, so again, of course Alpha will pay out 2.1.

But how much does it get back now in this credit event? Well, it held a CDS on the notional of 100 million, but in this case, there was a remaining value of the bonds of 40 million. There was recovery there, so of course, they're only gonna receive the difference there, the 100 minus 40, so they're gonna receive 60. So in this case, of course, the net cash flow for Alpha is the 60 that they received minus the 2.1 premium they paid out, so 57.9 net cash flows here for Alpha.