Introduction to Credit Default Swaps Case Solution And Analysis, HBR Case Study Solution & Analysis of Harvard Case Studies

Introduction to Credit Default Swaps Case Solution

On the other hand, the future contract would help the company in an easier and complex-free risk hedging against the risk of collecting account payment. It is because of the fact that the collection of receivables promote an increase in the exposure to foreign currency losses or gains,which is not entirely consolidated or eliminated. Both future and forward contract would ensure the consistent and quick collection of the account receivable-son a diverse base of industrial customers.(Conroy, 2008).

Credit default swap scenarios

Firm B defaults in a standard CDS.

If the firm B defaults in the standard credit default swap; the buyer of the credit default swap would get compensation on the basis of the contract’s settlement terms. There are various types of the settlement which include: physical settlement, cash settlement and fixed value settlement. In physical settlement, the investor tends to receive 100 million dollars in return on the basis of having the right to furnish the cheapest to deliver asset in return for investment’s face value. Additionally, in case of the cash settlement; the payment of 40 million would be made to the company against the loss. Furthermore, with the fixed recovery level of 30%; the company tends to receive 70 million dollar on a 100 million dollar investment.

Firm B defaults in a first-to-default basket

If the firm B would defaults in the first-to-default-basket; the buyer of credit default swap would surrender the reference asset and would obtain the face value from the seller of the credit default swap. Additionally, in case of default in first-to-default basket; the high-quality collateral would be liquidated and the proceeds would be used in order to cover the loss, which would be incurred to the protection buyer. By assuming that the Firm A has a credit spread of 300 basis point; the spreads of the firms that would be paid to the investor on the basis of premium, referring to the loss on the investment, would be 40 million dollars.

Firm A defaults followed by Firm B in a first-to-default basket

If the firm A defaults, followed by the Firm B, in a first-to-default basket; it shows that the event of one defaulting means that the company is not entirely independent on the event of the other credit in the basket defaulting, due to which the company would be entitled to get compensation in terms of sum of the spreads of the two firms’ credit. By assuming that the Firm A and Firm B have the credit spreads of 300 and 400 basis point, respectively;the sum of both the firms’ spreads would be paid to the investor as a basis of premium referring to the loss on the investment, would be 70 million dollars.

Firm A defaults in a senior basket with a $5 million first-loss limit.

Considering the event of default in the senior basket with 5 million dollar first-loss limit; the premium or compensation that would be paid to the investor using the credit-default swap would be 1 million dollar, which is calculated by taking the recovery amount of 4 million dollars from the first-loss limit amount of 5 million dollar, thus resulting in 1 million dollar compensation to be paid to the investor.

Valuing a Credit Default Swap

As per the information provided in the case; the hazard rate of reference entity per year is 2 percent, whereas; the recovery rate is 40 percent, the total life of credit default swap is 5 years and the spread is 150 basis points. Additionally, it is assumed that the LIBOR rate is 5%. The probability of survival is calculated by deducting 1 from the default probability for the entire period of 5 years. The expected payments from the default protection buyer to the default protection seller are calculated by taking the sum of the present value of the expected payments for 5 years.The present value of the expected payments is $6.1056.

In the similar manner, the expected value of the default protection buyer is calculated by taking the sum of expected payoff’s present value, which is calculated by multiplying the discount factor with the expected payoff. Thus, the present value of the expected payoff is $0.0498. The valuation of the expected payments from the default protection-buyer to the default protection seller, in the event of the default is done by calculating the expected payments and present value of expected payments. Hence, the total present value of expected payments is $0.6023..................

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Introduction to Credit Default Swaps Harvard Case Solution & Analysis