525 Week 12 Objectives
FBE 525 - Class Objectives -- J. K. Dietrich
Week 12 – November 9, 2006
Goals and Objectives
(1) Define and give examples of credit risk, relate credit risk to the rating transition matrix and to description of risks of investments in credit-risky financial instruments
(2) Describe the analysis of credit risk in a portfolio of investments and discuss the importance of joint probabilities of credit risk migration and covariances in the credit transition matrix in credit risk assessment
(3) Relate credit risk to catastrophe risk and describe how such risks can be hedged in capital markets
(4) List and define the important instruments used to hedge credit risk
Important Vocabulary List from Class
MIGRATION OF CREDIT RATINGS
JOINT PROBABILITIES OF CREDIT MIGRATION
RECOVERY RATES BY SENIORITY CLASS
STANDARD DEVIATION, PERCENTILE LEVEL OF RISK
CREDIT DERIVATIVES
First American Bank: Credit Default Swaps – Discussion Questions
Our purpose in analyzing this case is to understand the role credit derivatives can play in managing exposure to credit risk and to outline what must be known to value credit derivatives. The following questions are suggestions to guide your reading and our discussion of the case.
(1)What has been the recent history of CapEx Unlimited (CEU) and how would you analyze and describe its level of credit risk over the period leading up to the case?
(2)How and to what extent would the Charles Bank International (CBI) $50 million loan to CEU increase its credit risk exposure both to CEU and its loan portfolio? What elements would be important in making these assessments? How would they affect the pricing of the loan to CEU?
(3)How would a credit default swap on the $50 million loan to CEU affect the credit-risk exposure of CBI? Would CBI be completely relieved of credit risk, and if not, why not?
(4)What are the cash flows between the counter-parties (CBI and First American Bank) under the terms of the credit default swap? How would you estimate each of these expected future cash flows and specifically, what estimates and assumptions would be needed? Which data provided in the case are useful in making these calculations or estimates? Think carefully about these issues as we will discuss them at length.
(5)What are the basic principles that should be used to price the credit default swap? What are the economic conditions under which the swap will be negotiated and priced and how will they affect the final deal?
(6)How can First American Bank deal with the credit risk it has assumed by entering into the swap? What are the risks and competitive concerns with the alternative solutions?
Suggested Wall Street Journal (WSJ) or other Articles
October 28-29 , 2006
“A Risky Money Game” (B1) – Small retail market in currency trading develops
“Bids and Offers: Amaranth Trader Dreams of Second Act After Loss” (B3) – Losing $6 billion does not necessarily end career of commodities trader
“Merger Frenzy Among Exchanges Could Be Making Its Way to Asia” (B3) – Background story on possible alliance of NYSE and Tokyo Exchanges, the world’s largest
“Concern Over Brokers at Banks” ( B4) – Mixing products and cultures in pursuit of the financial supermarket raises regulatory issues
“Leveraged-Loan Game Is Set for More Growth” (B5) – Good follow-on story to Chase case in development of syndicated loan market
“Why Citi Doesn’t Need Shopping Spree” (B14) – Discusses possibility of breaking up Citigroup by traditional business line and value-creating strategy (so much for GLB)
October 30 , 2006
“Risk Management: As Home Owners Face Strains, Market Bets on Loan Defaults” (A1) – Good story on credit risk derivatives and role in speculation and hedging on consumer loan defaults
“Treasury Trading Draws Scrutiny” (C1) – Example of securities-market regulation, in this instance the most liquid market on earth
“Cantor Nears Public Offering of Unit” (C3) – Another public offering of securities firm illustrates winning strategies in the securities business
“EU Set to Endorse Code to Simplify Stock Settlements” (C3) – Problems with cross-border settlements addressed in policy, an example of inefficiencies from balkanization of markets
“Surge in Trading Is Bonus for Chicago Merc, CBOT” and “Nymex Screen Trading Is a Hit” (both C5) – Recent developments in the rapidly restructuring securities trading industry
October 31 , 2006
“U.S. Pension rule Lets Plans Lend Funds Overseas” (D4) – A regulatory change has important implications for asset-management business, illustrating significance of regulation in financial service firm strategies, as discussed two weeks ago
“Behind the British Debt Magic” (C1) – Discussion of growth of consumer debt and policy alternatives affecting the financial services business
“Goldman Builds Ambitious Role In Buyout Realm” (C1) – Blurring of business lines in financial markets as securities firm competes with commercial banks
November 1 , 2006
“Migrants’ Money Is Imperfect Cure for Poor Nations” (A1) – Growing international remittances business and overall size of market is discussed as part of economic impact of cross-border transfers of workers’ funds
“ISS Accepts Bid Of $553 Million From RiskMetrics” (A10) – Interesting segment of financial advisory business, proxy voting analysis, is bought by consulting firm that developed credit-risk analysis tools we discuss this week
“Lenders Get Help to Prevent Foreclosures” (A17A) – Discussion of causes and cures of consumer defaults, revealing the importance of consumer education, a topic of discussion in San Francisco itinerary
“GE Taps Mortgage Market in Mexico” (B3A) – Seeking new markets for consumer debt, GE looks to U.S. investors in Mexican residential real estate
“Big Board Plans to Close 20% Of Trading Floor” (C1) and “Nymex to Sell 7% Stake in IPO” (C4) – Continuing restructuring of exchanges as technological change occurs
“SEC Shines Light on Obscure Market” (C6) – Regulatory attention may change practices in the repurchase agreement markets, illustrating regulatory risk
“Rules on Capital Roil U.S. Bankers” (C3) – Discussion of Basel II and U.S. bank capital regulation relevant to regulation discussion and Basel II case
“Is Your Fund Manager Two-Timing You” (D1) – Principal-agent problem with asset managers running two businesses
“You Owe It to Yourself” Why Long Bonds Could Help Save Your Retirement Plans” (D1) – Illustration of duration problems in retirement planning
“Banks Take a New Tack on Mortgage Lending” (D3) – Pricing of mortgage loans becomes more important in tight consumer-lending market
November 2 , 2006
“In Some Places, U.S. Money Isn’t As Sound as a Dollar” (A1) – Interesting example of some of the costs of using cash
“Tracking the Numbers: Why Custody Banks now Have a g=Global Glow” (C1) – Discussion of same issues raised in State Street case and revealing growth in the custody market
“Canada Tax Move Hits Shares” (C12) – Sudden change in tax treatment of financial product causes major adjustments of share values, illustrating regulatory and taxation risk
“Bank of America Targets Wealthy Under $1 Million” (D6) – Definitions of wealthy change as financial firms seek assets to manage