QUESTION A
A Credit Default Swap is a swap that protects the lender from the risk of loss resulting from the default by the borrower. The protection buyer of the CDS (the lender) makes periodic income payments (CDS premiums) to the protection seller who in return guarantees to pay the lender the principal in case the borrower defaults.
Cash flows when there is no default
Notional amount = $1 million
Annual CDS premium = 4% × 1,000,000 = $40,000
Quarterly CDS premium = $10,000
If the borrower does not default, the protection seller will make a profit of $120,000 at the end of the third year ($10,000 every quarter). At the end of the term (3 years), the borrower will repay the amount borrowed ($1 million) to the lender (protection lender). The protection seller will not pay any amount since the credit event does not occur.
Cash flows when there is default
At the two year time when the borrower defaults, the protection seller bears the risk. The protection seller will make a payment of $1,000,000 million to the protection buyer (lender). When the borrower defaults, the protection buyer is entitled to the face value of the loan plus interest payments. Once the protection seller has paid the $1 million to the lender (protection buyer), the protection seller takes ownership of the loan. In this case, the protection seller will claim the amount from the borrower.
Increased risk of default after 2 years
The new CDS premium = 6% × 1,000,000 = 60,000
Risk-free rate = 2%
Probability of default = 6%
The value of the CDS should be equal to the present value of the expected payments. In this case, the discount factor used is based on the risk-free rate.
PVIF2%, 1 year = 0.980
The above discount factor is then adjusted with the probability of survival to determine the expected discount factor. In this case, the probability of survival is 94% (100 – 6%).
Expected discount factor = 0.98 × 96% = 0.9408
Present value of expected payment = 0.9408 × 60,000
= $56,448
I should be paid approximately $56,448.
Financial instruments
Returns
Government bond:
Return = 3% × 100 = $3 or 3%
Portfolio of corporate bond and CDS
No default
Return on corporate bond (coupon) = $10 = 10%
CDS premium = 3%
Net return on the portfolio = 10 – 3
= 7%
Default after one year
Net return = 7%. The protection seller would still pay the face value as well as the coupon interest hence there is no change in the return.
As shown above, the portfolio of the CDS and the corporate bond has a higher return than the government bond. The CDS protects the investor from default risk. Based on the above results, I would choose a corporate bond then transfer the associated default risk using a CDS.
Indifference
Probability of default = P
Probability of survival = 1 – P
Expected return = (1 – P)7 = 7 – 7P
Indifference situation: 7 – 7P = 5
P = 2/7 = 0.286
CDS more than the face value
It is possible for CDS investors can buy CDS protection of $300 million even when the ABC bond’s face value is $100 million. This is because any investor can buy a CDS on a bond even if the investor does not hold the bond. CDS protection does not require an investor t have a direct insurable interest. In this case, if ABC defaults, there will be a credit event auction and the amount received will be less than the face value.
QUESTION B
SolarCity would benefit financially if the deal goes through. As indicated, the company is no longer a growth company and has been struggling in the last years as it faces stiff competition from cheap energy products. Tesla is not struggling and the acquisition is viewed as a bailout to SolarCity. Besides, Tesla is a renowned manufacturer of battery-powered cars. SolarCity makes solar power products and will benefit from the already market of Tesla.
I think Tesla will lose financially if the deal goes through. SolarCity is struggling in the industry due to competition from cheap energy products. The company is burning out cash and the acquisition would be like a bailout to SolarCity. The greatest financial disadvantage may result from the nature of the products of the two companies. Tesla makes battery-powered cars but its battery –making unit is seen as the biggest. SolarCity makes solar energy products that may interfere with the market share of Tesla.
Possible red flags and/or shenanigans
Inappropriate members appointed to the group’s board of directors as highlighted by Schilit. The board compositions raises corporate governance issues. The board is not independently selected and members resorted to recusals.
The management is also attempting to avoid regulatory scrutiny by requiring all ligations to be filed in Delaware.
Poor earnings quality and a decline in ROC as evidenced by the fall in the company’s stock after the announcement of the acquisition.
QUESTION C
GB Staffing, Inc. offered 1,075,000 common shares of $0.01 par value at a price of $14.00 per share. The total amount to be raised by the offer was $15,050,000.
The net amount received by the company was $13,921,250. The difference was paid as underwriting discounts and commissions to the underwriters (Roth Capital Partners, LLC and Taglich Brothers, Inc.).
The underwriters took risks in this offering. The underwriting agreement obligated the underwriters to purchase a specific number of shares offered by the company of any of those shares were purchased. Each of the two underwriters were obligated to purchase 537,500 shares if any of the shares offered were purchased. In the risk factors section, the company outlined that its stock faces several risks to investors such as being a low volume stock, among other risks. By agreeing to purchase the above number of shares, the two underwriters took risks involved in the company’s stocks.
GeoInvesting argues that the conflict of interest is not a problem to the company. It argues that affiliates of the underwriter (Taglich Brothers) own more than 10% of the shareholding in the GB Staffing. It thinks that Taglich cannot take any action or decisions that would adversely affect the company and its dividends since they are shareholders in the company and anything that negatively affects the company will affect them in the same manner. The underwriter in question gains from the offering since it earns underwriting discounts and also gets additional shareholding in the company.
I think the adjustment is appropriate. The proceeds of the offering were to be used to reduce debt implying that interest expense will fall. The reduction in interest expenses increases net income hence increasing the EPS. This is added to the reported income in determining the adjusted EPS. Although the increase in shares outstanding dilutes EPS, the dilution is offset by the increase in net income.
Skin in the game refers to a situation where top corporate officials buy stocks in the company they own using their own money. This term was introduced by Warren Buffet.
It calls it information arbitrage since lack of perfect information about the real effect of the offer creates opportunities for making arbitrage profits. It is an arbitrage since most investors only see the dilutive effect. As the stock price falls, an investor with the correct information will buy the stock at lower prices and sell at a profit or gain when the EPS increases.
QUESTION D
The largest absolute difference was on 24th June (5.98). During these two days, the UK voted to leave the European Union (Brexit).
Largest change (in 2016) = 5.98
S&P contract multiplier = 250
Assuming futures with a value of $1,000
Mark-to-market value = 250 × 1,000 × 5.98
= 1,498,000
This would be a profit.
Part a: When the VIX futures is in Contango, the best strategy is short the front contract (Sutcliffe 193).
Part b: when the VIX futures are in normal backwardation, the best strategy is to long the front contract (Sutcliffe 193).
Works cited
Sutcliffe, Charles M. S. Stock Index Futures. London: Chapman & Hall, 2006. Print.
