Case Study on First American Bank: Credit Default Swaps
Question 1
A Credit Default Swap (CDS) is an instrument designed to transfer the credit exposure of fixed income products between parties. A CDS is also referred to as a credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default.
The protection buyer, protection seller and the third party are the parties involved in a CDS agreement. In this case, Charles Bank International (CBI) is the protection buyer, First American Bank (FAB) is the protection seller and CapEx Unlimited (CEU) is the third party who is borrowing the loan from CBI.(Refer to Appendix-Figure 1)
The reason why CBI would benefit is because in case CEU defaults on the loan, FAB would give out a guaranteed payment to CBI. In terms of lending to CEU, if the new loan of $50million is added to the existing loan, this would put CBI over its credit exposure limit. However, rejecting the loan could hinder the relationship ties between CBI and CEU. Thus, a CDS would help CBI reduce its credit risk as well as maintain a good relationship with CEU as the loan could be given out with a lower risk weight age added to it. The chances of FAB and CEU defaulting at the same time is quite low as FAB is a highly rated entity and so if CEU defaults on the loan there is some guarantee that FAB would pay it.
As for CEU, they could now exceed the limit and take the loan even though they are not aware of the CDS agreement. This could ensure that they could carry on with their expansion and need not be in a position to secure the loan from other sources. Lastly, FAB could now improve relationships with CBI and also receive a fee from CBI for the CDS. This fee could be
A Credit Default Swap (CDS) is an instrument designed to transfer the credit exposure of fixed income products between parties. A CDS is also referred to as a credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. A CDS is considered insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default.
The protection buyer, protection seller and the third party are the parties involved in a CDS agreement. In this case, Charles Bank International (CBI) is the protection buyer, First American Bank (FAB) is the protection seller and CapEx Unlimited (CEU) is the third party who is borrowing the loan from CBI.(Refer to Appendix-Figure 1)
The reason why CBI would benefit is because in case CEU defaults on the loan, FAB would give out a guaranteed payment to CBI. In terms of lending to CEU, if the new loan of $50million is added to the existing loan, this would put CBI over its credit exposure limit. However, rejecting the loan could hinder the relationship ties between CBI and CEU. Thus, a CDS would help CBI reduce its credit risk as well as maintain a good relationship with CEU as the loan could be given out with a lower risk weight age added to it. The chances of FAB and CEU defaulting at the same time is quite low as FAB is a highly rated entity and so if CEU defaults on the loan there is some guarantee that FAB would pay it.
As for CEU, they could now exceed the limit and take the loan even though they are not aware of the CDS agreement. This could ensure that they could carry on with their expansion and need not be in a position to secure the loan from other sources. Lastly, FAB could now improve relationships with CBI and also receive a fee from CBI for the CDS. This fee could be