HBS Case: Enron Corp: Credit Sensitive Notes

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Case: Enron Corp.: Credit Sensitive Notes (HBS Case 29709)
1. Credit Derivative
A credit derivative is defined as a financial contract that transfers credit risk that is linked to underlying entities or portfolios of underlying entities from a party to another exclusive of shifting the underlying. The rationale of credit derivatives is to transfer the credit risk and the income stream in regard to the borrowers without transferring the assets. Here, the credit derivative acts like an insurance policy permitting an originator to shift the risk on a credit asset (which he might or might not be the owners) to the seller of the security or counterparties. The credit derivatives permit institutions to diversify their portfolios without investing
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A CSN can be issued using a fixed rate plan, such that the issuer promises to pay preset coupons on the note based on its prevailing credit rating. Hence, the payoffs on the CSN differ only with changes in credit rating and not the interest rate or spreads. The CSNs were formed as a reaction to growing investor concerns about event risks and provided a hedge to investors to mitigate against the credit rating downgrades by imposing cost of rating reductions on the issuers in an earlier agreement. The costs to the issuer can be counterbalanced by possible gains from the improvements in the credit ratings. Unlike the FRNs, establishing a forceful rate schedule on the CSN issue, the issuer was in a position to credibly signal better prospects. Consequently, the CSN provides a mechanism for companies to signal their predictions of credit-improvements in a credible manner. The CSN’s issuer bears the downgrade risk in exchange for the likely upward gain signaling and lesser financing …show more content…
With the CSN issuance, Enron management perhaps assumed that they were a stable company with unwavering growth and high possibility that its credit rating would rise or remain the same. Exhibit 8 shows there is low probability for the firm to start paying greater payments on the CSN owing to the lower probability of a decline in the firm’s credit rating. Similarly, another benefit for Enron is the aptitude to issue notes with lower interest rate in comparison to the market rates for the notes issued by firm with similar credit

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