Case Study First American Bank: Credit Default Swaps

CapEx Unlimited (CEU), one of Charles Bank Internationals (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 CEUs default probability. The Merton Model proposed by Robert Merton characterizes a companys 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, CEUs market value of the firm equals to $10,900 million (S0) and the outstanding debt has a maturity of 5 years (T). CEUs 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 CEUs 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 * [1-N(d2)] S0*[1-N(d1)] Where P(D) = N(-d2)
Black Scholes Calculation Example Exercise Price=Debt Face Value Time to Expiration of Option Volatility of Equity 5 Year STRIP Yield Market Value of Firm P0 116.26 S0 10900 X 5200 r 0.045 T 4 X T sd rf So Sd 0.3 5200 5 30% 4.50% 10900 d1 1.8186 d2 1.2038 N(d1) 0.9655 P(D) N(d2) 0.8857 0.11434

Swap Fee Rate Calculation Now, assume we have an accumulated default probability of 10.52% within 5 years, which indicates a semiannual default probability of 1.052%. The notional amount equals to new loan $50 million with a recovery rate of 82% (Exhibit 14). The swap fee is paid semiannually coinciding with coupon of the bonds. At the time of the deal, the five-year risk-free rate was 4.5%. Set swap fee rate as s. As we know, in an efficient market, the cost of loss without swap should equal to fee payments. The calculation below is based on a notational principal of $1.
Expected LGD Cost at Default 18.00% 18.00% 18.00% 18.00% 0.1894% 0.1894% 0.1894% 0.1894% Expected Fee Payment 0.9895s 0.9790s 0.9684s 0.9579s PV Expected Cost 0.00185 0.00180 0.00176 0.00171 0.00712 PV Expected Fee Payment 0.9650s 0.9312s 0.8984s 0.8667s 3.6310s

Year

Default Probability

Survival Probability

Discount Factors

0.5 1 1.5 2 Total

1.05% 1.05% 1.05% 1.05%

98.95% 97.90% 96.84% 95.79%

0.9753 0.9512 0.9277 0.9048

Set total PV of expected loss cost equals to PV of expected swap fee. Then, s= =0.00712/3.631 = 0.00196, indicating the annual fee payment on a default swap with a notational principal of $1. Therefore, Annual Swap Fee = 2*s*$50,000,000 = $196,089 Swap Fee Rate Calculation The table below shows the cash flows from the swap.
Year Default Probability Suvival Probability LGD Expected Cost at Default 0.5 1 1.5 2 Total Expected Fee Payment Discount Factors PV(Expect ed Cost) PV(Expect ed Fee Payment)

1.05% 1.05% 1.05% 1.05%

98.95% 97.90% 96.84% 95.79%

18.00% 18.00% 18.00% 18.00%

94680 94680 94680 94680

96210 95187 94165 93142

0.9753 0.9512 0.9277 0.9048

92342 90062 87839 85670 355914

93835 90545 87361 84278 356019