Delphi Corp and the Credit Derivatives Market (A) Case Case Study Solution
Introduction
Delphi Corporation was a leading global automotive supplier with operations in more than 30 countries. The company was founded in 1994 as a spin-off from General Motors, and quickly developed itself as a key competitor in the automotive industry, providing a wide range of components and systems to major automakers such as GM, Ford, and Chrysler. Delphi's products included electrical and electronic systems, powertrain components, safety systems, and thermal management solutions.
At its peak, Delphi was the largest automotive parts manufacturer in the US and the major manufacturer in the world, with annual revenues of over $28 billion and more than 180,000 employees worldwide. However, the company faced a number of challenges in the early 2000s, including increased competition from low-cost manufacturers in Asia, rising healthcare and pension costs, and declining demand from its major customers.
In mid-2005, Birchfield Capital Management LLC known as a hedge fund specifying in investing in the debt of insolvent or near-insolvent US companies is contemplating what to do with its weighty share in Delphi Corporation's unsecured notes.
Delphi, a money-wise troubled worldwide auto parts manufacturer, is facing significant challenges, including declining vehicle sales, rising raw material prices, and significant obligations to its retired unionized workers, interpreting the company as bankrupt in its financial statements. Delphi's newly appointed CEO believes that the company can attain a significant restructuring without filing for bankruptcy, but Birchfield's portfolio manager is uncertain and is considering reducing the fund's exposure or hedging against potential losses using credit derivatives.
Problem Statement
As Delphi is facing significant challenges the major concern of the company is to analyze Delphi's financial situation and determine feasible investment approaches to exploit any market inefficiencies and resolve whether the usage of credit derivatives might improve the fund's investment yields.
Situational Analysis
Question 1: Expected Value
The first question requires the calculations of the estimated value of the default protection buyer for different maturities. The expected payoff is considered by multiplying the recovery rate by the default probability, which is calculated using the cumulative risk-neutral default distribution. The expected payoff is then multiplied by the discount factor to obtain the present value of the estimated payoff.
The recovery rate is assumed to be 40%, which means that if Delphi defaults, the protection buyer will receive 40% of the face value of the bonds. The discount factor is calculated using the riskless term structure, which is assumed to be flat at 3.5% per annum.
The expected payoffs decrease as maturity increases, reflecting the decreasing probability of default over time. The total expected payoff for the one-year CDS is 0.012, which represents 1.2% of the face value of the bonds.
If another one of Delphi's bonds are trading in the market for 5 points cheaper than the ones that Birchfield owns during the period after the bankruptcy filing but before the settlement auction, it would hurt Birchfield's profit. This is because the recovery value used in the settlement auction is based on the market value of the bonds at the time, so if the market value has decreased, the recovery value will also be lower, resulting in a lower payout for the protection buyer.
Question 2 (a): Cumulative Risk-Neutral Default Distribution
The Cumulative Risk-Neutral Default Distribution Probability, Survival Probabilities, and Default Probabilities are calculated based on the probabilities of default (PD) and CDS spreads for the corresponding maturities.
The survival probability is the probability that the reference entity will not default over the given maturity period. It is calculated as (1 - PD), where PD is the probability of default. For example, for a maturity of 0.25 quarters, the survival probability on 4/1/05 is 96%, which means that the probability of the reference entity defaulting over the next 0.25 quarters (or 3 months) is 4%.
The default probability is the complement of the survival probability, i.e., the probability that the reference entity will default over the given maturity period. It is calculated as PD. For example, for a maturity of 0.25 quarters, the default probability on 4/1/05 is 4%.
The CDS spread is the annual premium that the buyer of the CDS pays to the vendor in exchange for fortification against the default of the reference entity. It is articulated as a percentage of the notional amount of the CDS contract. For example, for a maturity of 0.25 quarters and a CDS fee of 370 on 4/1/05, the CDS spread is 24.47%, which means that the buyer of the CDS is paying an annual premium of 24.47% of the notional amount to the seller in exchange for protection against default over the next 0.25 quarters (or 3 months)..............
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