...Spencer Whitworth Ryan Scoville Austin Gray CTP 1: Credit Default Swaps With the financial crisis behind us, it is worth asking whether Credit Default Swaps (CDSs) were a positive development in our economic system. Many blamed the interconnections generated by primary and secondary CDS trading for the implosions that occurred in 2007, when the underlying assets on which the majority of CDSs were based - mortgage-backed securities - began to default. The media agreed, labeling CDSs with terms such as “weapons of mass financial destruction.” There are a number of aspects to CDSs, however, that skeptics and pundits overlooked. While history and intuition suggest important risks associated with CDSs that issuers, owners, and regulators must consider, there are a number of unexpected ways CDSs improve debt capital markets and our economy as a whole. On balance, these benefits shed optimistic perspectives on the merits of CDSs. If markets can learn from past mistakes, the advantages of CDSs render them indispensable financial instruments that contribute to better financing and information-gathering capability in our economy. Contrary to popular belief, the conceptual underpinnings of credit default swaps (CDSs) are surprisingly similar to those of traditional insurance policies. CDSs arose out of an ordinary transaction: a 1994 deal between J.P. Morgan, the European Bank of Reconstruction and Development (EBRD), and ExxonMobil. In return for an insurance-style premium to...
Words: 1553 - Pages: 7
...Question 7. CDS (Credit Default Swap) is designed to transfer risk from bond holders to CDS issuers. Bond holders buy bonds from a company and buy CDS from insurance company at the same time to make sure even the company default; the bond holders can get the par value back from insurance company. We will look at the CDS spread of Delphi for this question. After we plotted in the data, we find out that the overall CDS spread are abnormally large during the year of 2005 and 2008. The high CDS spreads indicates the unsuccessful operation of Delphi at that time and investors perceiving the possibility of Delphi defaulting on its bond payment. Delph is one of the world's largest automotive parts manufacturers originated in the U.S. The company originally belonged to General Motors (G.M.) and spun off in 1999 as an independent company. However, facing the increasing competition in the automotive industry, inability to repay its debt, and weakened by the high labor costs that set by the spinoff agreement with GM, Delphi filed for Chapter 11 bankruptcy protection on Oct. 8, 2005 to reorganize its struggling U.S. operations. After Delphi release the news of filing bankruptcy, the bond holders loosed confidence on Delphi and believed Delphi might default on its bond repayment. Bond holders started to sell Delphi bonds or purchase CDS to cover the bonds that they held. The CDS spread in 2005 therefore increased. The high CDS indicates the high possibility of Delphi defaulting on its...
Words: 711 - Pages: 3
...First Questions: 1. What is a default swap? How does it work? A credit default swap (CDS) is a credit derivative which provides insurance against the risk of default by a specific company or reference entity. This is an agreement between two parties stating that the buyer of the CDS, who is taking a short position in the credit event risk, will make a series of payments (known as the spread) to the seller for the full extent of the CDS life or until a credit event occurs, in exchange for a payoff if the underlying loan defaults. The spread of a CDS is the total amount paid per year to buy protection A higher CDS spread is considered to be more likely to default, and thus a higher fee is charge to receive protection against the company. Again, if a default occurs, the seller receives possession of the defaulted loan and the buyer is compensated with the notional amount or face value of the loan. The settlement in the event of defaults involves either physical delivery or a cash payment. Let’s use our case to illustrate how a default swap works. Using a credit default swap, CBI would make a periodic fee payment to First American Bank in exchange for receiving credit protection. First American Bank would assume the credit risk of the additional loan to CapEx Unlimited (CEU) by guaranteeing a payment to CBI if CEU defaulted on its debt. Banks are generally going to be the net buyers of credit protection while insurance companies tend to be selling these contracts. Hedge...
Words: 674 - Pages: 3
...serious problem. Operating Income Net Income 1981 99 110 1982 51 -33 % change -48% -130% In the early 1980’s, BF Goodrich needed to raise new funds. However, its credit rating had been downgraded to BBB-. The firm needed $50,000,000 to fund its continuing operations and aimed to lend long-term (8-10 years) debt at a fixed rate. Treasury rates were at 10.1 % and BF Goodrich anticipated paying approximately 12% to 12.5%. The firm was not willing to stipulate an agreement with its current bank, in order not to comprise the flexibility of its future choices. Goodrich wanted a fixed rate, but they believed it would have to pay about 13% for a 30-year corporate debenture. Rabobank Rabobank is one of the largest Dutch banks, consisting of more than 1,000 small agricultural banks. The bank was interested in securing floating rate financing on approximately $50,000,000 in the Eurobond market. Considering their AAA rating, Rabobank could issue fixed rate in the Eurobond market for 11% and for a floating rate of LIBOR plus 25 basis points. Without an active swap market it was common for swaps to be arranged between the two counter parties. Rabobank was interested in the deal but feared the credit risk, as Goodrich’s credit rating had recently been downgraded to a BBB- status. A direct swap would therefore expose Rabobank to credit risk. The two finally reached an agreement to use Morgan Guaranty as an intermediary. The following diagram shows all the transactions. Note: all the observed rates...
Words: 1867 - Pages: 8
...Table of Contents Problems with AIG and Credit Default Swaps 1 Financial Crisis 1 Why study AIG case 1 Define what a CDS is and history of AIG 2 AIG background 2 What are Credit default swaps? 3 What happened at AIG? 5 Why is the AIG case so special? 7 Government Reactions 8 Expert Opinion 10 Causes, How it can be Solved, Possible Ways it Can be Prevented 11 Works Cited 14 “Financial derivative products were financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." -Warren Buffett Problems with AIG and Credit Default Swaps Financial Crisis: Credit derivatives are believed to be one of the primary causes behind the financial crisis in 2008, and they continue to be an existing threat to the global economy in the future. Many economists have indicated that the breakdown in the credit derivatives market was the main reason behind the collapse of large corporations like Lehman brothers and AIG, as opposed to the subprime mortgage market. Why study AIG case: The failure of AIG can be primarily attributed to greed. Like many other insurance companies, AIG was too risky on credit default swaps. By the time of the crisis, the company had written more than $441 billion in swaps on bonds and securities, including mortgage-related securities. The collapse of the mortgage market unveiled the problems of credit derivative products and drew widespread attention to this huge and dangerous market. American International...
Words: 4563 - Pages: 19
...Can We Expect A Regulated CDS Market? Derivatives Project Xilin Yang (Celine) Introduction The article introduces credit default swaps and explores the problems of the credit derivatives. By analyzing the AIG’s bailout, the article describes the regulation gap in the CDS market and states the regulation reform after the crisis. Part I is background, generally introduces the Wall Street crisis. How it happened? What consequence it has? Part II is mainly about AIG’s CDS business: how AIG got involved in the crisis and why the biggest world insurance company suddenly collapsed. Part III is about credit default swaps: definition, construction, and problems. Part IV is concerned on the regulation reform after AIG’s failure. Wall Street Crisis Speaking of the Wall Street crisis, people all know it proceed from subprime crisis. The relatively low interest rate prompts banks to issue large amount of housing loans. To transfer default risk embedded in those loans, investment banks package those loans and mortgages into student loans, car loans and credit card debt, which form the so-called collateralized debt obligation (CDOs). All these derivatives depend on the housing loans. In the era of low interest rates, house prices rise rapidly and promote the rapid development of the housing loans business. With steady stream of housing loans into financial derivatives products, different ranks of products are packaged to sale out. The good view of economy makes those potentially risky...
Words: 2738 - Pages: 11
...What role dir moral hazard play in the United States financial crisis? Sub-prime lending People with no credit worth background could become credits easily all of the sudden. Reinvestment Act (passed in 1977, but revised in 1995 and amended in 2005) ( REFERENCE NIGEL) wants to make Hispanics and blacks more able to get credits, however the act missed the control function Moral hazard: Crazy loans. Interest only plans Everyone knew that they were unlikely to be ever paid back. Merrill lynch $55billion worth of securities on these books. “Home mortgages were purchased from banks and other lenders by Wall Street firms that packaged and divided them into different categories – based on the ability of borrowers to repay (see Foster & Magdoff, 2009, p. 94). They then were sold as investments” the riskier they are the more yield they generate. Lenders were happy because by selling to a bank they could make new loans. Banks were happy because of high volumes. Banks increase pressure on lenders to sell more morgages. Vicious cycle. Large sectors of the American industry outsourced companys to countries were labour is cheaper -> US many people unemployed -> less disposable income. At the same time government home ownership = American dream ← Credit default swap. o Packaging mortgages into a bond which then is sold to investors. Investors did not have to understand mortgages. Since this was rated by agencies such as standard & Poors, Moody’s triple A rating ...
Words: 540 - Pages: 3
...Sub prime mortgages The origins of the current crisis lie within the ashes of the equity bubble and subsequent collapse of the equity markets at the end of the 1990s With the collapse of the dot.com bubble, capital began to flow increasingly toward the real estate sectors in the United States The U.S. banking sector found mortgage lending highly profitable and saw it as a rapidly expanding market As a result, investment and speculation in the real estate sector increased rapidly As prices rose and speculation continued, a growing number of the borrowers were of lower and lower credit quality These borrowers, and their associated mortgage agreements (sub-prime debt), now carried higher debt service obligations with lower and lower income and cash flow capabilities New market openness and competitiveness allowed many borrowers to qualify for mortgages that they would not have qualified for previously Structurally, some mortgages re-set a high interest rates after a few years or had substantial step-ups in payments after an initial period of interest-only payments Housing bubble The bursting of the U.S. (United States) housing bubble, which peaked in 2006, caused the values of securities tied to U.S. real estate pricing to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of policies that encouraged home ownership, providing easier access to loans for (lending) borrowers, overvaluation of bundled sub-prime mortgages...
Words: 1414 - Pages: 6
...NBER WORKING PAPER SERIES THE EFFECTS OF QUANTITATIVE EASING ON INTEREST RATES: CHANNELS AND IMPLICATIONS FOR POLICY Arvind Krishnamurthy Annette Vissing-Jorgensen Working Paper 17555 http://www.nber.org/papers/w17555 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2011 We thank Jack Bao, Olivier Blanchard, Greg Duffee, Charlie Evans, Ester Faia, Simon Gilchrist, Robin Greenwood, Monika Piazzesi, David Romer, Thomas Philippon, Tsutomu Watanabe, Justin Wolfers, and participants at seminars and conferences at Brookings, Chicago Fed, Board of Governors of the Federal Reserve, ECB, San Francisco Fed, Princeton University, Northwestern University, CEMFI, University of Pennsylvania (Wharton), Society for Economic Dynamics, NBER Summer Institute, the NAPA Conference on Financial Markets Research, and the European Finance Association for their suggestions. We thank Kevin Crotty and Juan Mendez for research assistance. This paper was prepared for the Brookings Papers on Economic Activity Fall 2011 issue. We have received an honorarium for the presentation of the paper at Brookings. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. At least one co-author has disclosed a financial relationship of potential relevance for this research. Further information is available online at http://www.nber.org/papers/w17555.ack NBER working papers...
Words: 18319 - Pages: 74
...January 2013 Prudential Standard APS 112 Capital Adequacy: Standardised Approach to Credit Risk Objective and key requirements of this Prudential Standard This Prudential Standard requires an authorised deposit-taking institution to hold sufficient regulatory capital against credit risk exposures. The key requirements of this Prudential Standard are that an authorised deposit-taking institution: • must apply risk-weights to on-balance sheet assets and off-balance sheet exposures for capital adequacy purposes. Risk-weights are based on credit rating grades or fixed weights broadly aligned with the likelihood of counterparty default; and • may reduce the credit risk capital requirement for on-balance sheet assets and off-balance sheet exposures where the asset or exposure is secured against eligible collateral, where the authorised deposit-taking institution has obtained direct, irrevocable and unconditional credit protection in the form of a guarantee from an eligible guarantor, mortgage insurance from an acceptable lenders mortgage insurer, a credit derivative from a protection provider or where there are eligible netting arrangements in place. APS 112 - 1 January 2013 Table of contents Authority ........................................................................................................... 3 Application ....................................................................................................... 3 Interpretation...
Words: 24154 - Pages: 97
...1941 Derivatives and Risk Management Case Write-Up 3: First American Bank: Credit Default Swaps One of Charles Bank International’s (CBI) clients, CapEX Unlimited (CEU), has asked for a new $50 million loan. However, if CBI grants it this loan is exposure to CEU is too large, i.e. the concentration risk exceeds CBI’s internal guidelines. Now, CBI has approached First American Bank (FAB) to see if a credit default swap between FAB and itself can be established, which would mitigate the extra credit risk for CBI from the new loan. What is a default swap? How does it work? Generally, credit derivatives are contracts where the payoff depends on the creditworthiness of one or more companies or countries. These contracts allow firms to trade credit risk in similar to the way they trade market risk. Roughly, credit risk can be defined as the risk that borrowers or counterparties (in derivatives transactions) may default. Credit derivatives can be categorized as single-name or multiname contracts. A credit default swap (CDS) is a single-name credit derivative contract between two counterparties. It provides insurance against the risk of default (credit risk) by a particular company (the reference entity). The buyer of a CDS, who is taking a short position in the credit event risk, makes periodic payments to the seller of the CDS until expiry of the contract or the company defaults (this is known as a credit event). In return, the buyer receives protection in the form of the right to...
Words: 2127 - Pages: 9
...Published in The Hindu - Sunday Magazine on Oct 5, 2008 The bursting of the speculative bubble in the U.S. housing market has destroyed billions of dollars in investor wealth across the world, crippled the banking system, expunged close to a million jobs…and India has not been spared either. With banks failing by the day…definitely, these are uncertain times for the financial services industry. While many people who have lost their jobs, are faced with permanent shrinkage of their lifestyle, others in the industry are going through the trauma of not knowing if and when their turn would come. Who is to blame? Flashback to year 2003: Rohit (name changed to protect identity), a good friend of mine and someone who was officially considered to be a genius with an IQ of 150+, graduated from one of the leading IIM’s. Rohit managed to make it into the New York Headquarters of the most sought after firm that had arrived on campus for the first time – Lehman Brothers – a top U.S. Investment Bank (then). On joining, he was assigned to Lehman’s mortgage securities desk that dealt with Collateralized Debt obligations (or CDO’s). Following is an extracted transcript of a chat session I had with Rohit back in 2004: Me: So man, you must feel like you are on top of the world. Rohit: Yes dude, the job here is amazing, I get to interact with people around the world, investment managers – who want to invest millions of dollars Me: great…so tell me something interesting. What’s your job all about...
Words: 2208 - Pages: 9
...Bond Prices, Default Probabilities and Risk Premiums1 John Hull, Mirela Predescu, and Alan White A feature of credit markets is the large difference between probabilities of default calculated from historical data and probabilities of default implied from bond prices (or from credit default swaps). Consider, for example, a seven-year A-rated bond. As we will see the average probability of default backed out from the bond’s price is almost ten times as great as that calculated from historical data. Why are the two estimates of the probability of default so different? The answer is that bond traders do not base their prices for bonds only on the actuarial probability of default. They build in an extra return to compensate for the risks they are bearing. The default probabilities calculated from historical data are referred to as real-world (or physical) default probabilities; those backed out from bond prices are known as risk-neutral default probabilities. Real-world default probabilities are usually less than risk-neutral default probabilities. This means that bond traders earn more than the risk-free rate on average from holding corporate bonds. Risk-neutral default probabilities are used when credit dependent instruments are valued. Real-world default probabilities are used in scenario analysis and in the calculation of bank capital under Basel II. Altman (1989) was one of the first researchers to comment on the discrepancy between bond prices and historical default data. He showed...
Words: 3916 - Pages: 16
...1.0 Introduction Agricultural credit of late has become very scarce for smallholder farmers owing to a number of reasons. Credit institutions argue that smallholder farmers involve only themselves and are never willing to work collectively which limits the success of their business to where their skills and knowledge end. The nature of agribusiness itself leaves a lot to be desired as far as agricultural credit is concerned. Most agribusinesses have slow response to price changes, long-term production cycles, seasonality of production and are further susceptible to climate changes which culminate in cash flow problems and low long-term profitability hence posing high risk of default in payment of credit. On another note, though there are numerous credit institutions in Swaziland, loan processing is slow. Business enterprises in the country at times have to wait for months before their loans are approved (Dlamini 2001 in Ngcamphalala 2005). Although, there is an outcry of the scarcity of farm credit for smallholder farmers, other farmers do obtain funding from institutions that offer farm credit either in cash or in kind through the value chain finance instruments. Through some instruments, funds are advanced to farmers to be repaid usually in kind at harvest time yet through some instruments agricultural inputs are advanced to farmers or others in the value chain for repayment at harvest or other time with the cost of credit usually embedded into the price. Still through other...
Words: 2987 - Pages: 12
...Question 1 Sources of finance of high-tech firm There are a number of ways of raising finance for a business. The type of finance chosen depends on the nature of the business. Large organizations are able to use a wider variety of finance sources than are smaller ones. Sources of finance can be classified into internal sources (raised from within the organisation) and external (raised from an outside source). There are five internal sources of finance, owner’s investment, retained profits, sale of fixed assets, sale of stock and debt collection. There are also five external sources of finance, bank loan or overdraft, additional partners, share issue, leasing, hire purchase mortgage, trade credit and government grants. For a high-tech company, firstly, long-term sources of finance should be used. For example, owner’s investment should become the first fund of the company. Owner’s investment is money which comes from the owner’s own savings. It is the form of start up capital - used when the business is setting up, it also can be used for business expansion. Owner’s investment is a long-term source of finance and there is no interest needs to be paid. But owner’s investment is a limit to the amount because of the owner has a limited amount that can be invest. The founder should look for more money from other aspects in order to start up a new company successfully. Bank loan is a good choice for the founder. Bank loan is money borrowed at an agreed rate of interest over a set...
Words: 1969 - Pages: 8
