First American Bank: Credit Default Swaps
CapEx Unlimited (CEU), is a fast growing telecommunication company, who had been a loyal banking customer with Charles Bank International (CBI). With previous accumulated loans of $100 million, it now requires $50 million more to finance the expansion of its network in the middle of an industry shakeout.
The new loan is reasonable by itself, but when adding the loan to CEU’s existing loan would put CBI over its credit exposure limit with respect to a single client. Meanwhile, CBI does not want to damage their banking relationship with CEU. Subsequently, CBI turned to First American Bank, who has expertise in risk management and could be able to use credit derivatives to mitigate the credit risk exposure.
What is a default swap? How does it work?
A credit default swap contract was written for the event that the entity defaulted on its obligations. Through a single name credit default swap, which refers to a contract written on a single entity rather than a group or portfolio, a party could have bought protection from another party with respect to various predefined credit events occurring to a certain reference entity/obligation. The party buying the protection (equivalently going short the credit) was called the “protection buyer.” The party selling the protection (or equivalently going long the credit event risk) was called the “protection seller.” In exchange for getting credit protection, the protection buyer pays a periodic fee to the protection seller until the contract expires or a credit event occurs. In exchange for the contingent payment, the protection seller either received the underlying asset, known as “physical settlement”, or the determined market value of the asset in cash, known as “cash settlement”.
In this case, CEU is looking for credit protection for the additional $50 million in principle. In exchange for...
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