Suppose that in the credit default swap market a CDS contract on bonds issued by company A is trading at 75 basis points. We suppose that this means that a company can sell a 1 million dollar CDS contract and receive $75,000 per year for five years paid on January 1st each year. The CDS contract will then commit the seller to pay the buyer 1 million dollars if the company defaults on its bond payments at any time during the five years. (In the event of a default the contract is settled and no further payments take place). Suppose that a CDS contract on bonds issued by company B is trading at exactly the same price as that for A.

(a) Estimate the probability that the company A defaults during the next year assuming that the CDS is priced in a way that makes the expected profit from selling the CDS as zero, and assuming that default probabilities do not vary during the 5 years. Explain any other assumptions that you make.