First American Bank : Credit Default Swap Harvard Case Solution & Analysis

Fact Pattern

The years 2000 till 2001 were challenging for CapEx Unlimited which is the banking customer of Charles Bank international as it is going through the tough time by recording the loss of $82 million. Around $100 million of loan is previously pending from Charles Bank International which is lent on the basis of the relation with the bank for additional funding. An amount of $50 million is required to expand the business in the economy where there is an industrial shake. If CapEx limited provides funds to the Charles Bank International, then its exposure will increase with it. Through credit default swap, the managing director of First American Bank plans to mitigate the risk of Charles Bank International.

First American Bank falls in the category of the third largest American bank with reported asset that has the carrying value of $50 billion and it is expanded around 50 countries. The first American Bank’s product branch structure also contains its credit derivatives, which acts as an independent business unit.

The business nature of the CapEx Unlimited is based on the telecommunication industry, which focuses on the markets of Midwest United States, and Northeast market.The services that are being offered by CapEx Unlimited are high speed internet, providing services of data networking, Web Hosting, and conferencing.

Kettleprovides a facility to awide range of investors for its current swap situation, in a way they felt confident and straightforward. In receiving the credit protection from FAB, Charles Bank International made a payment in exchange for this protection. There are two ways for reducing the credit risk, one is from issue a credit linked notes, and the second is the providing greater rating of FAB.

Investors that purchase the protection from them are called as: protection buyers and the individual which provides protection are called as “protection seller”.

The total value of long term debt outstanding in the CEU balance sheet has amounted to $5 billion. The credit rating of CEU however, does not affect its credit rating. The term and conditions attached with the acquiring of new loan from the bank area characteristic of effective coupon rate with is approximately 9.8% and having two years maturity. First, American Bank will receive the semiannual payment of swap from the CEU in exchange of the protection that are provided to the CEU which is subjected to the interest payment that is received over CEU loan.

There was an issue with the Kittles in making decision which consists of providing the credit risk in house of Kittles or to identify the potential investor who is willing to accept the credit risk. There is a chance of arising of high counterparty risk, in case if Kittles transfers the credit risk to other party on the low rating rate, as their hedge is unfunded. Due to the nature of the owning the fund, the credit linked note is an attractive choice for quintupling the transfer risk.

Diagnostics

For determining the accuracy of the default credit swap, the first step is to determine the assessment of credit risk. The probability of the risk that CEU will be defaulted at the end of the second year is 13.7%, but this systematic data is not reliable as it is based over the historic component of information, which is not reliable for the calculation for pricing of derivative. In order to estimate the reliability calculation of CEU probability, Merton Model is used.

The characterization is done through the Merton Model in making the decision of the company’s equity either to write a call option or buy option over the assets of the organization with the X maturity rate and the strike rate price of the option is equal to the par value of the debt. The expected volatility of default that arises over the loan can be regarded as the implied volatility.

 The market value of the firm is calculated about $10,900 million and the debt with the outstanding maturity having the period of 5 years. The market value if the debt of CEU is reported around $4100 million having the face value greater than $4100 million. 5 years maturity is of treasury strips that have the par value of $5109 million, if the value of $4100 million is the market price of Treasury STRIPS. Therefore the reliable value of the debt can be estimated as $5200 million, which is equal to the price of the strike option. If the equity volatility is given in the information, then the option price can be easily determined. By using the Black-Scholes formula, the price of the strike rate option can be determined as 0.11..................

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