HBS Case Study

First American Bank: Credit Default Swaps

SUNWOO HWANG*

* KDI School of Public Policy and Management, Hoegi-ro 87, Dongdaemun-gu, Seoul, 130-868, Korea.

Introduction

Introduction

Charles Bank International (CBI) Protection Buyer

(A rump sum or) periodic payment

Payment

First American Bank (FAB) Protection Seller

The

st 1

Issue

Pricing the CDS spread

The fair value of the CDS spread is the number that sets the initial value of the CDS contract to zero.
The 1st Issue Kittal had to determine the semi-annual fee to be charged to CBI for the default swap Solution - Pricing a CDS

V = (PV Payoff) s(PV Spread) = where s: spread : present value of a dollar paid at time t : marginal default rate from now to year t : survival probability until the end of year t f: recovery rate (see exhibit 14) r: risk-free interest rate (See Exhibit 8. Treasury STRIP yields)

Pricing the CDS spread (cont.)

But, how to compute the marginal probability of d(t)? Apply the Merton model and, in turn, compute the fair value of CDS spread using the marginal probability.
In the Black-Scholes model, N(d2) is also the probability of exercising the call, or that the bond will not default. Conversely, 1 N(d2) = N(-d2) is the risk-neutral probability of default. where

Parameters Computation

* N(.) is the cumulative distribution function for the standard normal distribution

S: Market value of the CEUs asset = $6.8 + $4.1 = $10.9bn K: Strike price or the face value of the bond = FV(Current market value of the bond)
: Time to maturity or duration = 4.2 years : Implied volatility = 49.9%

Pricing the CDS spread (cont.)

The fair value of the CDS spread is the number that sets the initial value of the CDS contract to zero. We compute it using the default probability and recovery rate.

Pricing the CDS spread

Probability (%) Year t 0.5 1 1.5 2 Total Default. k(t) 0.0514 0.0488 0.0463 0.0439 Survival S(t) 0.9486 0.8998 0.8536 0.8097 Risk-free Int. Rate 1.47% 2.14% 2.67% 3.20% Discount Factor P V(t) 0.9927 0.9788 0.9607 0.9380 Payoff Payments Expected k(t)x(1-f) 0.0093 0.0088 0.0083 0.0079 PV 0.0092 0.0086 0.0080 0.0074 0.0332 Spread payments Expected sxS(t-1) 0.0093 0.0088 0.0083 0.0079 PV 0.0092 0.0086 0.0080 0.0074 0.0332

CDS spread = 92.52bp!!

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The

nd 2

Issue

Solution to the Second Issue

To hedge its risk exposure to the credit event occurrence of CEU, FAB may issue a credit-linked note (CLN), which is structured security that combine a credit derivative with a regular bond.
The 2nd Issue Kittal needed to ensure that First American Bank could hedge its end of the default swap by selling off the credit exposure in the form of another default swap or through another means. Solution

Credit Default Swap

Regular Bond

Credit-Linked Note

Option

Bond

Structured Product

Some of the principal amount are able to be used to cover the loss given default.
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Accounting interpretation

The note is a liability on the banks balance sheet.

B/S (CapEx Unlimited)

Asset Liability

B/S (Charles Bank International)

Asset Liability

B/S (First American Bank)

Asset Liability

$100m $50m

$100m $50m

$100m $50m

$50m

Cash
Debit Credit

Credit-Risk Hedged Loan

Debit Credit

$50m

$50m

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CLN Structure

CLNs are notes with an embedded short position in a CDS on CEU. In a CLN, the buyer of protection transfers credit risk to an investor via an intermediary bondissuing entity, which can be the buyer itself or a special purpose vehicle (SPV).

First American Bank (FAB)

OR

SPV

CLN CapEx Unlimited (CEU)

R $ 50m

$ 50m LIBOR + R1+R2 Contingent Payment

LIBOR+R2

Investor N-1 Investor N

Top-rated Asset

Source: Financial Risk Manager Handbook, Jorion, P., Wiley, 5th edition, 2009.

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Charles Bank International (CBI)

R1 Contingent Payment

(Top-rated Asset in trust + CRS)

Investor 1 Investor 2

$ 50m

CLN Structure (cont.)

The investors initial funds are placed in a top-rated investment that pays LIBOR plus a spread of R2. The FAB or SPV takes a short position in a credit default swap, for an additional annual receipt of R1. The annual payment to the investors is then LIBOR + R1 + R2.
First American Bank (FAB)
OR

SPV

CLN CapEx Unlimited (CEU)

R $ 50m

$ 50m LIBOR + R1+R2 Contingent Payment

LIBOR+R2

Investor N-1 Investor N

Top-rated Asset

Source: Financial Risk Manager Handbook, Jorion, P., Wiley, 5th edition, 2009.

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Charles Bank International (CBI)

R1 Contingent Payment

(Top-rated Asset in trust + CRS)

Investor 1 Investor 2

$ 50m

Additional Remarks

Pros and Cons Investors receive a high coupon but will lose some of the principal if CEU defaults on its debt. This structure achieves its goal of reducing the banks exposure if CEU defaults. In this case, because the note is a liability of the bank, the investor is exposed to a default of either ECU or of the bank FAB. Attractiveness Relative to a regular investment in, say, a note issued by the government of the United States, this structure may carry a higher yield if the CDS spread is greater than the bond yield spread. This structure may also be attractive to investors who are precluded from investing directly in derivatives.

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