Credit Default Swap Free Essay Example, 1500 words

The CDS will terminate either at the bond’s maturity or the date a default event occurs, whichever comes first. If default never occurs, General Motors continues to pay the periodic coupon payments and at maturity pays the principal portion of the bond to the investor, and the investor pays the CDS premium payments to Morgan Stanley until the bond matures. Morgan Stanley will never have to make any payments and profits for assuming the credit risk of the bond. If a default event occurs before the set maturity, Morgan Stanley instantly compensates the protection buyer for its loss and has no further obligations in the CDS contract. In this event, the investor would have minimized its losses by entering into the credit default swap. Question 3 A fair price (value) of Credit Default Swap would involve calculating the present value of periodic premium payments equal to the asset backed value of the entity at the time of maturity of the loan or the probable time of default. This would then be added to a payment for the possibility of default which is based on the recovery rate. We will write a custom essay sample on Credit Default Swap or any topic specifically for you Only $17.96 $11.86/pageorder now Both items will be discounted to present value. Question 4 The structure and timing of the cash flows that would be made between First American Bank (FAB) and Charles Bank International (CBI), if they agreed on credit default swap to support the two year  £50 million loan that CBI is hoping to make to CapEx Unlimited (CEU) would be as follows: - the standard fee payment period is semi-annually. The payment will involve the risk free interest rate with a premium added to allow for the credit risk involved. This credit risk will be based on the credit rating which was last BB and which suggests that CEU is speculative. It will also involve an additional charge for the possibility of default which his based on the recovery rate expected on this event. The risk free rate at the time of the deal was 4.5%. This rate is comparable to the 5 year Treasury STRIP yield of 4.51% but way above the 2 year Treasury STRIP yield of 3.2%. That is a difference of 1.3%. The credit spread for 2 year and 5 year by maturity and at the closest available rating related to the telecommunications industry were 260 basis points and 256 basis points respectively. This translates to 2.6 and 2.56% respectively. The credit spread and the risk free rate applicable would be 3.2% plus 2.6% equals 5.8%. An extra default premium should be added to account for the above average risk. Question 5 The option pricing approach to firm default risk to calculate the CEU’s expected default frequency (EDF) during the next five years will be the Black-Scholes Option Pricing Model.