Case Analysis Report On First American Bank: Credit Default Swaps Case Overview It was April April 20 2002, 02, when when Chris Chris Kittal Kittal (Manag (Managing ing direct director or at frst frst Americ American an Bank’s credit derivatives in ew!ork Cit!" received an #rgent call $rom a contac contactt at Charles Charles Bank Bank Intern Internati ationa onall (CBI" (CBI",, CBI is a medi# medi#m%s m%si& i&ed ed 'ank 'ank approached '! one o$ its corporate clients in need o$ additional fnancial $#nding )he client Cap*+ #nlimited (C*" a $ast growing telecomm#nication compan! has 'een one o$ the most lo!al c#stomers o$ the CBI since last fve !ears, as the compan! is $acing a to#gh time d#e to the ind#str! shakeo#t, compan! compan! needs needs mone! mone! to over overcome come these these circ circ#m #msta stance nces s and asked asked the 'ank to lend them -.0 million (to e+pand its network" additionall! along with e+isting -/00 million loan )his doesn’t so#nd m#ch $ascinating $or 'oth the partie parties s (end (ender er 1 'orro 'orrower wer"" 'eca#s 'eca#se e this this incre increase ases s the e+pos# e+pos#re re o$ risk risk (e$a#lt risk" $or the Cap*+ and this will also 'e a'ove the limit to give loan to a single c#stomer, whereas 'ank co#ld get the higher interest charges '#t the de$a#lt risk was two$old, a threat $or 'ank too, o$ not getting mone! 'ack B#t 'ank did not have the option to den! the loan re3#est immediatel! 'eca#se this co#ld h#rt their relationships with Cap*+, so the 'ank had to decide a wa! 'etween, which co#ld provide some c#shion to 'ank as well, so the 'ank called Kittal and he readil! s#ggested them credit de$a#lt swaps 4irst American Bank had 4irst American Credit erivatives erivatives as an independent '#siness #nit ho#sed within frst American str#ct#red prod#ct’s 'ranch )he gro#p had e+pertise in risk management 1 fnancial engineering to provide clients with risk management and investment prod#cts Cap* Cap*+ + #nli #nlimi mite ted d on the the othe otherr hand hand had had cont contin in#o #o#s #sl! l! #pgr #pgrad aded ed and and e+panded e+panded its in$rastr#c in$rastr#ct#r t#re e in order order to keep keep pace with growing growing c#stomer demand, this is the reason the! wish to 'orrow additional mone! $rom CBI Kittal s#ggested Credit e$a#lt 5waps to this sit#ation 'eca#se the! were simple and confdential and made the credit risk accessi'le to a 'road range o$ investors
4or this CBI wo#ld make a periodic $ee pa!ment to 4AB in e+change $or receiving credit protection Credit de$a#lt swaps are more like a hedging tool, which has a long position (6rotection 5eller" and short position (6rotection '#!er" 6rotection '#!er pa!s the $ees to protection seller Investor can also speci$! the mat#rit! o$ the 5waps
Isolating Credit Risk: As the risk is 'eing trans$erred $rom CBI to 4AB, so now Kittal needed all the necessar! in$ormation to isolate and val#e credit portion o$ C*7s risk! de't I$ C* received -.0 million $rom CBI their long term de't 'ecame -. 'illion, '#t CBI wanted protection on additional -.0 million onl! Another matter o$ concern was the rating o$ the C*’s p#'licall! traded de't, which was 'elow investment grade (with a B2 rating $rom Mood!’s" )he co#pon rate o$ this new de't was 89: and a mat#rit! o$ two !ears C*’s e+isting de't had average mat#rit! o$ fve !ears and a semi%ann#al co#pon pa!ment o$ -/;0 million, de't had a market val#e o$ -</ 'illion and average !ield o$ 8=: Keeping in view all the pa!ments, risk ret#rns 1 some limitations o$ Credit de$a#lt 5waps, now Kittal has to do a cost and 'eneft anal!sis o$ this option to 'e decisive a'o#t the matter >no / ?hat is Credit e$a#lt 5wap@ ow does it work@ ?hen a person have re$erence o'ligation ie corporate 'ond, m#nicipal 'ond, mortgage%'ack sec#rities, credit risk ( ina'ilit! to repa! the co#pon and principal amo#nt within specifed time", wants to trans$er the credit risk to third part! In this case, )he Credit e$a#lt 5wap helps him, which is 'ilateral contract 'etween two parties in order to trans$er the risk $rom one part! to another part! It is like ins#rance against a compan! de$a#lting on its de't o'ligation A person who wants to trans$er the credit risk or '#! the credit de$a#lt swap is called protection '#!er and the other part! is known as protection seller ?hen protection '#!er got involve in C5 he periodicall! pa!s the protection seller the pre%specifed C5 $eeC5 spread which is some 'asis point on the notional amo#nt 3#arterl! ?hen protection '#!er 'ears the de$a#lt on its notional amo#nt and onl! a'le to recover some portion o$ notional amo#nt, he stops the pa!ment to the protection seller and give him the recovered
amo#nt and in against the protection seller protect him '! providing him his $#ll notional amo#nt
!" A# $%at is t%e pro&a&ility of default for C'()
4rom the given data in the e+hi'it /0('" the pro'a'ilit! that C* will de$a#lt in its ten#re o$ 2 !ears with the rating o$ Ba2 is /;: while the pro'a'ilit! o$ de$a#lt in the /st !ear is =2;: and the pro'a'ilit! that C* de$a#lts d#ring the second !ear (given it didn’t de$a#lt d#ring the frst" is /;: % =2;: )here$ore the s#rvival rate is the diDerence o$ the /00: and the c#m#lative de$a#lt pro'a'ilit!
"no !" B# $%at are e*pected cas% +ows for default Swaps)
)he frst ta'le shows the e+pected cash Eows in $orm o$ *+pected cost o$ de$a#lt and e+pected pa!ment o$ the principal o$ -/ and their present val#e in order to determine c#rrent worth o$ the credit de$a#lt swap )he disco#nt $actor #sed in disco#nting the $#t#re cash Eow is the risk%$ree rate 'eca#se as we wanted to calc#late val#e on the 'asis o$ the risk ne#tral cash Eows ?hile the second ta'le shows the cash Eows specifcall! related to the C* amo#nt the! want to 'orrow '! $ollowing the same disco#nt $actor the val#e is determined
"no! C#" $%at discount rate s%ould &e used to discount e*pected cas% +ows) )he disco#nt $actor which we have taken $or disco#nting the e+pected $#t#re cash Eows is as $ollowF
)hese are calc#lated on the 'asis o$ the risk $ree rate as <.: (isco#nt rate" '! the $orm#la asF isco#nt $actorG/ (/H00<." t ?e have taken risk $ree rate $or fnding o#t the disco#nt $actor 'eca#se with this we ass#me C5 to 'e less risk! as compared to the other hedging sec#rities and i$ we see the data given in e+hi'its the pro'a'ilit! o$ s#rvival is high and pro'a'ilit! o$ de$a#lt is ver! low
",o"-" S%ould FAB %old on t%e credit risk of C'() .ow s%ould /ittel transfer t%is credit risk from FAB0s &alance s%eet) ?hether to keep or pass on the credit risk o$ C* depend #pon the risk tolerance level o$ 4AB and risk%adJ#sted ret#rn $rom keeping the credit risk o$ C* and $rom passing it to another part! I$ 4AB wants to keep the credit risk, it will receive the periodic $ee $or 2 !ears, which is calc#lated in the previo#s 3#estion )o earn the periodic amo#nt as a $ee 4AB has to p#t aside an additional amo#nt $rom his capital e3#al to ins#red amo#nt, which CBI gave to C* )he more the additional capital the! p#t aside $rom their capital the more the! can 'ear the risk and vice versa In order to determine the risk%adJ#sted ret#rn, 4AB sho#ld calc#late the ret#rn a$ter keeping the credit risk o$ C* and calc#late the ret#rn on the same amo#nt, which the! p#t aside to keep the credit risk '! investing it in an! other so#rce I$ the ret#rn generated via keeping the credit risk is more than investing the same amo#nt elsewhere, then going towards keeping the credit risk is s#ita'le option I$ 4AB do not want to keep the credit risk, it can pass it to an! third part! like edge 4#nds or ow%rated Banks, via credit de$a#lt swap contract, which keep sa$e the 4AB $rom e$a#lting owever, this method has a pro'lem
'eca#se when the protection seller has a low rated credit worthiness, this means the! might de$a#lt even 'e$ore completion o$ contract ere the CBI has de$a#lt risk $rom two parties frst de$a#lt risk o$ C* and the de$a#lt risk o$ 4AB, 'eca#se 4AB is entering via contract with low%rated 'anks, which has high chances o$ de$a#lt 5o in order to protect himsel$ $rom de$a#lt 4AB needs to fnd a wa!, which is more attracted than de$a#lt swap 5o iss#ing a credit%linked note is the 'est option to attract the investors (swap '#!ers", 'eca#se it is a $#nded credit derivative that has em'edded credit de$a#lt swap C (it is like the sec#riti&ation mechanism" ena'le the 4AB to trans$er its credit risk to investors (who p#rchase the notes" via note and receive the mone! $rom them and gives them the !ield, which 4AB receives $rom C5
Su&mitted Date: Roma 1!23!2!134 Ru5aiya /al%oro Arslan /%an Syed S%ams (ddin
By: Israni
