Final answer:
By buying a risky bond with a rate of LIBOR + 5% and short selling a risk-free bond at LIBOR, an investor creates a situation similar to a long position in a CDS and receives a net positive cash flow of $1.25 per quarter. The correct answer to the question is (c) II and III, indicating that the investor has replicated a long CDS position and receives net positive quarterly cash flows.
Step-by-step explanation:
The question at hand involves the replication of credit default swaps (CDS) through a combination of buying a risky bond and short selling a risk-free bond. When an investor purchases a risky bond that pays LIBOR + 5% and shorts a risk-free bond paying just LIBOR, they are creating a position that resembles a CDS. The risky bond pays a higher interest rate reflecting the credit risk premium, while the risk-free bond represents the baseline LIBOR rate.
If the investor shorts the risk-free bond, they are obligated to pay the LIBOR rate while receiving LIBOR + 5% on the risky bond. This results in a net cash flow difference of 5% annually, broken down quarterly into 1.25%. Since interest is paid quarterly and assuming no default, the investor will receive a net positive cash flow, disproving options (IV).
Comparing this to the mechanics of a CDS, taking a long position in a CDS would mean the investor benefits if the reference credit defaults, which is akin to owning a risky bond and being exposed to the risk premium (higher interest payments); whereas, shorting the risk-free bond is like selling protection, as the investor pays out if there is a default. Since there is no default assumed in the question, the investor is essentially on the receiving end of the risk premium without having to pay out for a default event, replicating a long position in a CDS, thereby disproving options (I).
Therefore, the correct answer is (c) II and III: the strategy replicates a long position in a CDS and results in a net positive cash flow of $1.25 per quarter for the investor.