First American Bank

In: Business and Management

Submitted By fengfan1988
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Case Study – First American Bank: Credit Default Swaps
CapEx Unlimited (CEU), one of Charles Bank International’s (CBI) important clients, asked for $50 million to finance its network expansion. However, the new loan would put CBI over its credit exposure limit. CBIT contacted First American Bank (FAB) to establish a credit default swap, which would mitigate its credit risk from the new loan. What is the probability that CEU will default within two years? In order to accurately price the credit default swap, we need to start with an assessment of credit risk – the probability of default. According to Exhibit 10b, the probability that CEU (rating B2) will default by the end of year 2 is 13.7%. But, this data only reflects historical information, which is not appropriate for derivatives pricing. Therefore, we use Merton Model to calculate CEU’s default probability. The Merton Model proposed by Robert Merton characterizes a company’s equity as writing a call option or buying a put option on the assets of the company with maturity T and a strike price equal to the face value of the debt. The implied volatility from options can be regarded as the expected probability of default. Currently, CEU’s market value of the firm equals to $10,900 million (S0) and the outstanding debt has a maturity of 5 years (T). CEU’s market value of debt is $4,100 million, so its face value of debt should be more than $4,100 million. For treasury STRIP with 5-year maturity (r=4.5% according to Exhibit 8), if its market value is $4,100 million, its face value will be $5109 million. Therefore, it is reasonable to estimate that CEU’s face value of debt is $5,200 million, which equals to option strike price X. If the volatility of equity (sd) is given, then we can easily get the price of option and the probability of default by using the formula below. (See table below an example) P0 = X*e-rt *…...

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