From Free Lunch to Black Hole: Credit Default Swaps at AIG Harvard Case Solution & Analysis

From Free Lunch to Black Hole: Credit Default Swaps at AIG Case Solution

Introduction

The case talks about issues faced by one of the biggest insurance company, American International Group. The issues AIG faced relate to managing the credit risk of other parties, using the most innovative techniques that are widely used and could provide solutions to parties that are unable to bear the risk of credit. Moreover, they could be transferred to the ones that could bear the risk that are mainly the financial institutions, which are also known as Credit Default Swaps. However, due to some wrong investment decision made by the management of AIG and some of the features of these instruments, the company was unable to achieve its desired results.

Credit Default Swaps

Credit Default Swap is an insurance instrument that could transfer the risk of default from one entity to the other, mainly the financial institutions. The swap agreement between two parties is designed in such a manner that in the case of default from an entity, the seller or the financial institution considers the overall payment to the buyer of credit default swaps. In return, the buyer of the credit default swap makes the regular payment until the life of the contract or until the event of default.

Certain terms are used in this scenario, the overall agreement is done for the entity whose chances are that it could default payments in the future, and this entity is referred to as the Referencing Entity. The event of default from that referencing entity is also known as Credit Event. The regular payment made by the buyer of the protection is based on the predetermined fixed rate per year, which is also known as CDS rate that is multiplied by the face value of the loan to derive the annual regular payments.(Terry Young, April, 2010)

In this whole scenario, the seller of the CDS, which in our given case is AIG, protects against the default risk on a corporate debt or mortgage based securities. The common reasons of credit events include bankruptcy, restructuring of the company, or the other reasons of failure of payment. The overall mechanism of credit default swaps is that the buyer would make the regular payments over the life of the contract or until that credit event whichever is shorter and in return, the seller of the protection covers the overall default risk from the referencing entity. The default events, interest rates, as well as the recovery rates are assumed to be mutually independent. Thus in the case, if the credit event occurs priory, then there would be no payments to the seller of the protection. (OPTIONS, 2003)

The valuation of Credit Default Swaps is done using the following formula:

Expected Present Value of Contingent Leg - Expected Present Value of Fixed Leg

 The reason why CDS and the yield on the default able bond are related to each other is that both the concepts focus on the market perception of credit risk and the returns expected from the risk is equal to the loss expected from that risk, which also holds true in the bond market. However, there are certain factors that are contributing towards the difference between them, also known as basis and are computed from the difference of the two. The reason behind the explosive growth in the CDS market during the financial crisis is the strong trust on its performance to mitigate the default corporate debt and allow the financial institutions to trade credits at the most reasonable cost in a liquid market. (Jakola, June 2, 2006 ).................

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