CASE STUDY

First American Bank: Credit default Swaps

First American Bank: Credit default Swaps

Introduction

Banks exist to make profits to their shareholders, and a lot of the time, that it exactly what happens. Its not all smooth sailing though, banks are often exposed to various risks while attempting to generate profits. One of it is Credit risk. Credit risk can be defined as a delay in receiving payments arising from solvency(Chacko, Strick, 2002). To estimate the amount of credit risk a bank has they have to either consider what type of assets the bank might have and also what sort of exposure their personal clients and related industries have toward its financial system. Some bank managements limit these exposures to a certain percentage of the banks capital base. This report analyses the various aspects of credit risk by evaluating the case study First American Bank: Credit Default Swaps.

Default Swap

Credit Default Swap are a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. They were invented by Wall Street in the late 1990's, are financial instruments that are intended to cover losses to banks and bondholders when a particular bond or security goes into default(Merton, 1974).

Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff if the company defaults within a certain period of time, while the “protection seller” collects periodic payments for assuming the risk of default.

For many, it is the basic building block of the credit derivatives market. According to the British Bankers' Association Credit Derivatives Survey, it dominates the credit derivatives market with over 38% of the outstanding notional. Its appeal is its simplicity and the fact that it presents to hedgers and investors a wide range of possibilities that did not previously exist in the cash market. In the forthcoming section, we set out in detail how it works. We also survey many of these new possibilities(Chacko, Strick, 2002). 

CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to speculate on market changes. The credit default swap is the basis for the credit derivatives market. In 2001, credit default swaps accounted for 38% of the credit derivatives market, which was more than two times that of the next highest contributor. Today, credit default swaps continue to dominate the market, and are used as the foundation of newer, more complicated products. For example, a credit default swap index (CDSI) is a single product based on a basket of credit entities (Chacko, Hecht, Sjoman, Hao, 2005).  A default swap is a par product: it does totally not hedge the loss on an asset that is currently trading away from par. If the asset is trading at a discount, a default swap overhedges the credit risk and ...