Case Study on First American Bank: Credit Default Swaps Essay

2193 Words Apr 7th, 2013 9 Pages
Question 1
A Credit Default Swap (CDS) is an instrument designed to transfer the credit exposure of fixed income products between parties. A CDS is also referred to as a credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default.

The protection buyer, protection seller and the third party are the parties involved in a CDS agreement. In this case, Charles Bank International (CBI) is the
Therefore, when the value of the assets is more in-the-money (that is when the value of assets is closer to zero), the probability of default will also be higher. On the other hand, if it is out-of-the-money (right side of the strike price), we can presumably say that the probability of default is zero.

Finally, the probability of default can be predicted with increasing precision when the time of coupon payment or maturity draws nearer. Default only occurs on the coupon/expiration date when the shareholders will decide if they would want to pay the outstanding debt and pass the assets of the firm back to the bondholders or just let the put option expire.

Question 3
We approach this question with an assessment of the credit risk, which is also the probability of default (PD). There are various methods in estimating the default probabilities of CEU. Firstly, using ratings and historical probabilities will enable us to deduce some default rates. However, these estimated PDs are based on historical values and we should look at other models with risk neutral probabilities instead. The rationale of using risk-neutral probabilities is because these values are derived based on market prices of various financial instruments, unlike the actual probabilities that are based on a fitting statistical model by manipulating historical values as shown in the above paragraph. In addition, the Bond prices model was inappropriate

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