...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
...Assignment 5 What is a credit default swap (CDS)? How does it work? Do you think it contributed to the 2008 financial crisis? Should it be banned in the market? Basically, credit default swap is a credit derivative which its function is like insurance contract between two counterparties on one or more companies' loan or bond. One party who buys the protection called "protection buyer" has to pay a periodic premium to another party called "protection seller" until expiry of the contract, in return for protection against a credit event (financial difficulty such as bankruptcy, failure to pay or restructuring) of a known reference entity (company). The protection buyer receives protection in form of the right to sell bonds issued by a particular company for their face value or receives principal amount of loan if the company defaults. An example from the case, Charles Bank International (CBI) wanted to lend $50 million to CapEx Unlimited (CEU) company. However, if the amount was lend to CEU, the bank would have high risk exposure to the company and the risk exceeded CBI's risk guidelines. Thus, CBI bought a CDS on CEU company from First American Bank (FAB), these method would mitigate the extra credit risk for CBI from the new $50 million loan. CBI had to pay a periodic fee to FAB until the CDS expired. In this case, if CEU company defaulted before the contract expired, FAB would pay the principal loan amount. The settlement in the event of default involves either "physical...
Words: 937 - Pages: 4
...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 Group is a perfect example to explain the potential...
Words: 4563 - Pages: 19
...Harvard University ECON-S 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...
Words: 2127 - Pages: 9
...Outlining the major objectives of your essay • Analyse the major factors causing global financial crisis • Analyse the role of OTC derivatives in triggering the global financial crisis • Recommend the ways to control the OTC market in the future The origins of the global financial crisis There are several factors causing global financial crisis: 1. Growth of housing bubble & Subprime lending o particular advantage of low long-term interest rates was the US mortgage market. American households traditionally took out fixed-rate mortgages, often guaranteed by the government-sponsored enterprises, the GSEs. As rates fell, households refinanced in large numbers, but this extra origination business dried up once rates started to rise again. Rather than shrink their business, US mortgage lenders pursued riskier segments of the market that the GSEs did not insure, as Graph 4 shows. This included the sub-prime segment, but also so-called ‘Alt-A’ and other non-standard loans involving easier lending terms. At the time, this was considered a positive development, because it was thought that it allowed more people to become home owners. Products requiring low or no deposit, or with a low introductory interest rate were known as ‘affordability products’. They allowed households to pay the very high housing prices that their own stronger demand was generating. o http://www.rba.gov.au/Speeches/2009/_Images/150409_so_graph4.gif o As the US housing...
Words: 3039 - Pages: 13
...What is a credit default swap (CDS)? How does it work? Do you think it contributed to the 2008 financial crisis? Should it be banned in the market? Basically, credit default swap is a credit derivative which its function is like insurance contract between two counterparties on one or more companies' loan or bond. One party who buys the protection called "protection buyer" has to pay a periodic premium to another party called "protection seller" until expiry of the contract, in return for protection against a credit event (financial difficulty such as bankruptcy, failure to pay or restructuring) of a known reference entity (company). The protection buyer receives protection in form of the right to sell bonds issued by a particular company for their face value or receives principal amount of loan if the company defaults. An example from the case, Charles Bank International (CBI) wanted to lend $50 million to CapEx Unlimited (CEU) company. However, if the amount was lend to CEU, the bank would have high risk exposure to the company and the risk exceeded CBI's risk guidelines. Thus, CBI bought a CDS on CEU company from First American Bank (FAB), these method would mitigate the extra credit risk for CBI from the new $50 million loan. CBI had to pay a periodic fee to FAB until the CDS expired. In this case, if CEU company defaulted before the contract expired, FAB would pay the principal loan amount. The settlement in the event of default involves either "physical delivery" or...
Words: 303 - Pages: 2
...to rob banks, steal cars or even leave the house. Computers are thieves’ new weapon of choice. They can hack in to bank accounts in seconds, leaving a person helpless and feeling violated while months are spent picking up the pieces. In this cyber age people do not even have to change out of their pajamas, or brush their teeth to steal every dime a person has. Computers are the perfect weapon because they do not need food, sleep and can be programmed to constantly run, bouncing from account to account ruining every life it touches. With all the theft going on, some are committing suicide because they cannot fix all the damage these thieves have done to their lives. The big Internet crimes reported on the news are kids file sharing music. File sharing is considered a form of theft, but sharing one album compared to thieves ruining lives stealing billions from people who live check to check is like comparing apples and oranges. The creators of technology could not even have imagined all the bad stuff that has become of their dreams and hard work. Computers were built to solve calculations and then kept evolving to help make life easier and more efficient. Trouble started with the World Wide Web, because people started transmitting personal information through the airways. People do not understand some stuff that is sent over the web, one does not have control on who can collect that information. When people are talking about kids stealing music, the first thing that...
Words: 1259 - Pages: 6
...Friendly Cards Liu Xing 1. In order to calculate the WACC of Creative Design, we need to estimate the beta first. We can calculate the beta(e) from the weighted beta(e)s of the industry. According to Exhibit 5: βe of American Greetings=1.07 and the net income is 33.4, βe of Gibson Greetings=0.93 and the net income is 24.1. So we estimate theβe of CD: 1.07*33.4/(33.4+24.1)+0.93*24.1/(33.4+24.1)=1.01 Re of CD=Rf+βe(Rm-Rf)=8.4%+1.01*7%=15.47% According to Exhibit 7, the Debt of CD=2250 D/V=2250/4500=50% From Exhibit 6, the interest of 1987 is 100, Rd=100/2250=4.44%, Rtax=95/238=40% WACC=15.47%*50%+4.44%*50 %*(1-40%)=9.07% If we consider the CD’s Equity as it’s market value, which is 11 times of it’s 1987 earnings, the Equity=171*11=1881, the D/V will be bigger, and WACC will be smaller. 2. The purpose we do the projection is to determine whether we should acquire CD, so we need to consider the improvements Friendly intends, they are: Reduce COGS by 5%, other expense by 10%, and sales increase by 6% per year. Using the COGS/Net Sale and Total Expense/Net Sales of 1987, we can estimate that of 1990. When estimate the debt, we use the same rate as Interest/(COGS+Expense) in1987，because Debt is more closely related to the COGS and Expense. Then the income statement of 1990 is as follow: | Income Statement |1987 |1988 |1989 |1990 | |Net sales |5,000 |5,000 |5,300 |5,618 | |COGS |3,075 |2,921 |3,097 |3,282 | | Gross profit |1,925 |2,079 |2,203 |2,336...
Words: 731 - Pages: 3
...CORPORATE FINANCE 307 LITERATURE REVIEW Student Name / ID: Chay Yu Xi 15907811 Jacqueline Teo Hui Yun 15805054 Ting Heng Huat 14973837 Tutor: Leo Kee Chye Tutorial Day / Time: Monday / 2pm Table of Contents Abstract The Tech Bubble Introduction Lowering of Interest Rates Adjustable Rate Mortgage Securitization Mortgage Backed Securities Collateralized Debt Obligation Credit Default Swap Government Reaction and Policies Emergency TARP Repercussions Basel Disadvantages Future Policy Requirements Controversy Conclusion Reference List Review of the causes of the 2008 Financial Crisis in US. Abstract This paper seeks to summarize a stream of research that has delved into the major causes of the financial crisis in 2008. More precisely, we will be looking at a combination of causes such as the sub-prime mortgage crisis, the mortgage backed security, the collateralized debt obligation as well as how the incidental credit-default swap contributed to the incident. This paper will begin from analyzing the past, when it happened and how it built up and resulted in the financial crisis. The significance of this literature review seeks to give a simplified explanation of the financial crisis of 2008 and will be useful for the people unversed in economics or finance but wish to have a basic understanding of its causes and history. The Tech Bubble During the early 2000, numerous companies and individuals bought new operating...
Words: 7947 - Pages: 32
...Received (in revised form): 12th December 2010 Samuel Francis is an attorney and certified public accountant experienced in corporate, litigation, audit and tax matters focusing his practice on financial services and investment management. He holds a BS in accounting from the City University of New York, Brooklyn College and a JD from Fordham University School of Law. He is the author of the 2009 award-winning article ‘Meet Two-Face: The Dualistic Rule 10b-5 and the Quandary of Offsetting Losses by Gains’. Fordham Law Review 77(6): 3045–3094. Correspondence: Samuel Francis, 321 Roselle Avenue, Cedarhurst, NY 11516, USA E-mail: samfrancis@optonline.net ABSTRACT At the center of the global financial crisis of 2007–2008 was the collapse of American International Group, brought on by extensive unhedged positions in derivatives, such as credit default swaps, and possibly exacerbated by mark-to-market accounting rules. Even though these rules generally produce the most realistic valuations of derivatives, a heated debate broke out over their application in a dislocated market. The foremost concern was that forcing financial institutions to mark down assets to their current market prices actually causes further declines. Regulators largely dismissed such concerns, but acknowledged that the existing standards could use additional clarification and modification. Many scholarly studies have since concurred that the rules should not be replaced, but suggest that additional measures should...
Words: 6287 - Pages: 26
...2.2 Stylized facts 20 Section III: Empirical analyses 26 3.1 Effect of rating events on investors’ behavior 27 3.2 Effect of business cycles on investors’ behavior surrounding rating events 33 Conclusion 46 Reference list 48 Appendix 52 Section I: Rating symbols & definitions 52 Section II: Tables 54 Section III: Figures 56 Section IV: Extended theory 57 Section V: Graphs 59 Section VI: Data 67 Section VII: Testing classical assumptions 71 Abstract Firstly, this paper investigates if investors react to changes in sovereign credit ratings. Hereby rating changes for European, Non-European and European Union countries are considered for the period: 1990-2011. Using both bond spreads and credit default swap (CDS) spreads as measures for investors’ behavior, analysis shows that changes in sovereign credit ratings significantly affect these spreads. Furthermore evidence is found that a rating downgrade of a sovereign country has a bigger impact on the spreads than a rating upgrade. Secondly, it is theoretically...
Words: 21349 - Pages: 86
...AIG Presentation Matthew Fong Minkyung Lee Yesl Lee Koo chul Jung Contents History of AIG Financial Crisis of AIG Bailout Policy Bonus Payments Outrage Conclusion Bibliography Cornelius Vander Starr - Established an insurance agency in Shanghai, China. -The first Westerner in Shanghai to sell insurance to the Chinese in 1949. -Management of the company’s lagging U.S and holdings to Maurice R. Greenberg. M.R.Greenberg -American businessman and former chairman and CEO of AIG -The world’s 18th largest public company. -Selling insurance through independent brokers rather than agents to eliminate agent salaries. -Currently CEO of C.V.Starr and Company. 1919 American Asiatic Underwriters(AAU) -Sell American insurances in Shanghai. Asia Life Insurance Company - Target is Chinese to sell life insurance - Hong Kong, Indonesia, Philippine, Jakarta. 1926 American International Underwriters(AIU) - Header agent in America, they were guarantee for American’s accidents.(started from Home foreign business) -New strong agent in Latin America around 1930~45 1968 -Starr died and Greenberg became a CEO 1970 -Greenberg was succeeded as CEO by Martin J,Sullivan. -Martin J. Sullivan began his career at AIG in London Office. 1984 -AIG listed their stocks on New York stocks exchanges and AIG be came the largest insurance company. 2005 -Became embroiled in a series of fraude investigations conducted by the Securities and Exchange Commission...
Words: 1169 - Pages: 5
...direction on financial system reforms that might help anticipate and alleviate future Systemic Crisis. The report was written in 2008 in response to the crisis that was ongoing at that time. It is good to note that getting 15 scholars to agree on 37 recommendations is something worth of appraisal. However, one cannot but point that the report is somehow disjoint in its arrangement of chapters. I articulate that this slight disorder is because of the limitations of making 15 experts agree. This disjoint attribute has not prevented the report from being very constructive and direct in addressing very important policies and sensible issues relevant to reform. The paper has two central principles that the recommendation have been built on. The first is that policymakers have to consider how new regulations will affect not only individual firms, but also the financial setup as a whole. The second principal states that firms should be responsible for the costs of their failure and excessively risky positions. This principal aims at protecting taxpayers, the innocent bystanders, from the wrong doings of irresponsible corporate planning on the behalf of greedy market participants. These two principles can be considered the core of what is really the Squam Lake Group’s philosophy. Yet the report has its shortcomings. The...
Words: 4495 - Pages: 18
...Oligarchs Cate Reavis Free enterprise is always the right answer. The problem with it is that it ignores the human element. It does not take into account the complexities of human behavior. 1 —Andrew Lo, Professor of Finance, MIT Sloan School of Management The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy. 2 —Simon Johnson, Professor of Entrepreneurship, MIT Sloan School of Management, Former Chief Economist, IMF On October 9, 2007 the Dow Jones Industrial Average set a record by closing at 14,047. One year later, the Dow was just above 8,000, after dropping 21% in the first nine days of October 2008. Major stock markets in other countries had plunged alongside the Dow. Credit markets were nearing paralysis. Companies began to lay off workers in droves and were forced to put off capital investments. Individual consumers were being denied loans for mortgages and college tuitions. After the nine day U.S. stock market plunge, the head of the International Monetary Fund had some sobering words: “Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” 3 1 2 3 Interview with the case writer, April 10, 2009. Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009. “IMF in Global ‘Meltdown’...
Words: 10022 - Pages: 41
...last two investment banks Goldman Sachs and Morgan Stanley threw their towel and converted themselves to holding companies. The investment banking arena will never look the same again. Unfortunately the woe does not end here. American money-market fund the safest of safe investments has reported a loss (first time since 1994). If investors flee the money markets for treasuries, banks will lose funding and the contagion will suck in hedge funds and corporations. The recent turmoil has been blamed on the sub-prime mess. These relatively unregulated financial institutions’ greed has led to their downfall. What these “hedge-fund operators, leveraged buy-out boys and whiz-kid quants” have created is a financial Frankenstein. They have created loans for borrowers, who in real life do not qualify for them because of their poor credit ratings and low incomes. The risk of these loans have been passed on to investors around the world who are eager to buy securities carrying higher yields rather than those offered by safer investments such as US treasury bonds. According to an article by Knowledge @ Wharton “Mortgage-backed securities are created by assembling thousands of loans into bundles and creating a series of bonds that pass borrowers' principal and interest payments on to the bond owners. Typically, there is a series of bonds of increasing degrees of risk reflecting the borrowers' creditworthiness. The riskier bonds pay the highest yields but are the first to lose value if borrowers...
Words: 1010 - Pages: 5
