QUESTION A
Credit Default Swap
It is a financial instrument lenders use to hedge default risk. The lender acquires a CDS and pays premiums to the CDS seller who takes the default risk (Lasher 200). If the borrower defaults, then the CDS seller pays the par value of the loan to the lender. The CDS seller also pays the protection buyer accrued interests on the loan during the intervening period.
Cash flows in case of no default
Annual CDS premium = 4% × 1,000,000 = $40,000
Quarterly payments = 40,000/4 = $10,000
A will pay quarterly CDS premiums to B for the three years. At the end of the term, the lender (A) will receive the face value of the loan from the borrower (Lasher 200). In this case, the CDS seller (B) does not pay any amount to B since the borrower has not defaulted.
Cash flows when there is default after 2 years
A will still pay CDS premiums as shown in the table above. However, if the borrower defaults, the liability is transferred to B (the protection seller). When this happens, the protection seller (A) pays B $1 million in addition to any accrued interests then takes ownership of the loan from A. It will then be upon B to claim the amount due from the borrower.
Increase in default risk
CDS premiums = 6% × 1,000,000 = $60,000
Risk-free rate = 2%
The value of the CDS is the present value of its expected payments for the remaining year. This is equal to the PV of expected payoff by the CDS seller.
Expected payments = $60,000
Present value interest factor (2% for one year) = 0.9803
Present value of expected payments = Payments × Probability of survival × PV interest factor
Probability of survival = 100 – 6 = 94%
PV of expected payments = 60,000 × 94% × 0.9803 = $55,288.90
Financial instruments options
Returns on the financial instruments
Return = Coupon rate = 5%
Portfolio of corporate bond and CDS
With no default
Coupon rate on corporate bond 10%
Less CDS premium (3%)
Net return on the portfolio 7%
With default
Coupon rate on corporate bond 10%
Less CDS premium (3%)
Net return on the portfolio 7%
If there is a default, the CDS seller pays the lender the face value of the bond and any accrued interests. It will then take ownership of the bond from the investor. Therefore, default of the issuer does not affect the return to the investor.
The portfolio has a greater return than the government bond. This indicates that using CDS can be beneficial to an investor who wants to maximise returns while minimising the risk associated with the bond.
Probability of default
Expected return as a function of probability of default, P
= Probability of survival × return
= (1 – P)7
= 7 – 7P
An investor is said to be indifferent between two options when they generate a similar return. In this case, the return on the portfolio should be equal to the return on the government bond.
7 – 7P = 5
P = 2/7
= 0.286
Investors who do not hold the underlying ABC bond are allowed to purchase CDS protection. Buying CDS protection is not restricted to investors with a direct insurable interest in the bond. Therefore, it is possible for investors to buy an aggregate CDS protection of $300 million when the ABC bond has a value of only $100 million.
QUESTION B
SolarCity will benefit financial if the acquisition takes place. It is burning out cash and struggling with stiff competition from more affordable solar energy products in the industry. The acquisition will help bailout SolarCity.
There are indications that Tesla will be the loser. This includes the company and its shareholders. The company will spend a lot of money to acquire SolarCity, but the financial benefits are not guaranteed. As seen in the negative reaction of the stock market, the Tesla will lose. Investors already suffered losses as a result of the fall in Tesla’s stock price.
The possible red flags and shenanigans include:
There have been attempts by the management to avoid regulatory scrutiny. It required all shareholder litigations to be filed in Delaware. Lawsuits against the deal are expected.
The inappropriate composition of the board of directors resulting in a conflict of interest and corporate governance concerns.
Poor earnings/expected earnings as seen by the negative reaction of the stock market.
QUESTION C
The company offered 1,075,000 shares for sale. The shares were offered at a price of $14.00 per share giving a total of $15,050,000.
It received $13,921,250. The difference was the underwriting commission paid to Taglich Brothers and Roth Capital Partners, LLC.
The underwriters were obligated by the agreement to buy shares of the company in case any of the shares offered were bought. Therefore, they undertook the same risks faced by other investors in the stock of the company.
GeoInvesting argument is that the shareholders of the underwriter also own a considerable shareholding in the company. Therefore, they would not take any decisions that would compromise the company and its earnings as well as dividends since such actions would affect them directly. The offer enables the underwriter to gain through additional shares and underwriting discounts.
I think the adjustment is appropriate since the effect of debt reduction on the company’s net income must be incorporated in the EPS analysis. The decrease in debt expected from the offering will lead to a decline in interest expense thereby increasing the net income. This will have a positive impact on EPS that is why it is added to determine to the adjusted EPS.
Skin in the game is a phrase introduced by Warren Buffet. It implies a case where executives or officials in a corporation purchase shares of the corporation using their money.
They call it information arbitrage since an investor can make arbitrage profits by buying the shares with the knowledge of the positive impact of the offer on EPS. Most investors ignore the positive impact hence they sell their stocks. An investor can buy the stock at lower prices and gain when the prices increase as the EPS improves.
QUESTION D
The largest difference was experienced on 24th June. During the two days, there was Brexit vote where the UK voted to leave the EU.
Mark-to-Market Value
Largest change = 5.98
S&P contract multiplier = 250
Notional value of the futures = $50
Mark-to-market value = 250 × 50 × 5.98
= 74,750
This is a profit since the value of the futures increased.
Strategies
The best strategy if the futures is in Contango is to short the futures contract. Using a long strategy would lead to losses.
In the case of backwardation, the investor can gain if he/she adopts the strategy to long the contract.
Works cited
Lasher, William. Practical Financial Management. Mason, Ohio: Thomson/South-Western,
2016. Print.
