QUESTION A
Definition of Credit Default Swaps
A CDS is an instrument used to transfer the risk of default or credit exposure between two or more parties (Fabozzi and Kothari, 2008). It protects the lender from the possible loss of default by the borrower. The lender (protection buyer) pays premiums to the CDS seller. In return, the CDS seller guarantees to pay the lender the face value of the loan plus interests due in the intervening period if the borrower defaults.
Cash flows
Annual CDS premium = 4% × 1,000,000 = $40,000
Quarterly payments = 40,000/4 = $10,000
The borrower does not default hence the protection seller (B) will not have to pay A (the protection buyer) the face value of the loan. In this case, B makes a profit of $10,000 each quarter for the three years.
Cash flows when the borrower defaults after 2 years
CDS premiums = $10,000
When the borrower defaults at the end of the two years, B (the protection seller) will pay the face value of the loan ($1 million) to the protection buyer (A) plus unpaid interest during the intervening period. B will take ownership of the loan from A and will follow up with the borrower for the repayment of the loan (Choudhry, 2004). A pays CDS premiums to B in exchange for protection from the risk of default by the borrower.
When there is increased risk of default
The CDS premiums increase from 4% to 6%.
CDS premiums = 6% × 1,000,000 = $60,000
Risk-free rate = 2%
The amount I should be paid for the CDS should be equal to the present value of the CDS. The present value of the CDS can be determined by calculating the present value of the expected payments (Brigham and Houston, 2015). The present value of expected payments should be equal to the present value of payoff to the seller. In this case, the risk-free rate is used as the discounting rate.
PV of expected payments = CDS premiums × Probability of survival × PV factor
PV factor (2% for 1 year) = 0.9803
Probability of survival = 100 – 6 = 94%
PV of expected payments = 60,000 × 94% × 0.9803
= $55,288.90
The three financial statements
Returns of government bond and portfolio of corporate bond and CDS
Government bond
Coupon rate = 5%
Return after one year = 5%
Portfolio of corporate bond and CDS
With no default
Coupon rate on corporate bond = 10%
CDS premium = 3%
Net return on the portfolio = 10 – 3 = 7%
With default
Coupon rate on corporate bond = 10%
CDS premium = 3%
Net return on the portfolio = 10 – 3 = 7%
The default does not affect the return to the investor since the CDS seller pays the protection buyer the face value of the bond and interest accrued in the intervening period (Gottesman and Bossu, 2016).
As shown above the portfolio of CDS and corporate bond generates a higher return than that of the government bond. This implies that an investor earn a higher return by investing in the risky bond then transfer the default risk to the CDS seller.
Indifference between the two options
Probability of default = P
Probability of survival = 1 – P
Expected return as a function of P
= Probability of default × return
= (1 – P)7
= 7 – 7P
An indifference situation occurs when the returns from the two options are equal.
The return on government bond = return on the portfolio of corporate bond and CDS
7 – 7P = 5
P = 2/7
= 0.286
CDS greater than bond’s face value
CDS investors can buy protection that is more than the face value of the underlying debt in aggregate (Lasher, 2016). It is not a requirement for an investor to hold the bond to buy CDS protection. Having a direct insurable interest in the bond is not a requirement for a CDS investor to buy a CDS protection.
QUESTION B
The financial beneficiary
SolarCity will be the biggest financial beneficiary if this deal succeeds. The company is struggling in the industry as it faces stiff competition from cheap sources of energy. It will also gain from the established market of Tesla. The company is burning out cash, and the acquisition bails it out as viewed by the critics of the deal.
Financial losers
Tesla tends to lose financially if the deal succeeds. SolarCity is struggling in the market, and there is no clear way in which Tesla will tap into its solar energy products market share. Tesla is just bailing SolarCity. Investors in Tesla will also lose financially if the deal succeeds and the group fails to achieve its objectives. Already the company’s stock has gone down following the announcement of the proposed acquisition.
Red flags and shenanigans
The management is attempting to avoid regulatory scrutiny. It has required all shareholder litigations to be filed in Delaware where the laws are less stringent.
The group has appointed inappropriate people to the board, and this has raised serious corporate governance concerns. The board is not independent as members have conflicts of interest.
The board formation process is not appropriate. They didn’t select an independent board and members resorted to recusals.
Indications of poor earnings as shown by the fall in Tesla’s stock.
QUESTION C: A LONG RECOMMENDATION
Shares offered
The company offered 1,075,000 common shares for sale. The par value of the shares was $0.01, and the offer price was $14.00 per share. The total amount was $15,050,000.
Net amount received
The company received a net amount of $13,921,250 with the difference being paid out to the two underwriters as underwriting discounts.
Underwriting risks
The two underwriters undertook risk since the agreement required them to buy 537,500 shares of the company should any of the shares offered to be purchased. Buying the shares of the company has several risks as outlined in the prospectus. The company’s stock is a low volume stock hence the underwriters may not be able to resell them as fast as they could wish. They undertook the same risks as investors in the company.
Conflict of interest
GeoInvesting argues that the conflict of interest is not a problem since the underwriter would not do what harms the company because of the shareholding it has in the company. The offer benefits the underwriter since the underwriter gets the underwriting discount besides the additional shareholding in the company.
The adjustment
The adjustment to include the effect reduction in interest expense on the EPS. The reduction of debt reduces the interest expense. However, the adjustment does not include the tax effect of interest expense. Interest expenses are tax allowable hence reduces in income tax expense.
Skin in the game
It means a case where senior company officials purchase stocks in their company using their own money.
Information arbitrage
It is referred to as information arbitrage since access to some information creates arbitrage profits (Lasher, 2016). Investors that are not aware of the positive impact of the offer on EPS would sell their shares and, as the share price falls, investors with the perfect information can purchase the shares. They will gain when the EPS improves and stock prices rise.
QUESTION D
The biggest absolute difference occurred on 24th June (5.98). The UK had a referendum about the UK’s future in the European Union on 23rd June. They voted to leave the EU.
Largest change in 2016 was 5.98
S&P contract multiplier = 250
If the futures have a value of $10, mark-to-market value will be as follows:
Mark-to-market value = 250 × 10 × 5.98
= 14,980
The above value represents a profit.
Strategies
In the case of Contango, short is the best strategy.
In normal backwardation, the best strategy is to long the contract.
Bibliography
Brigham, E. and Houston, J. (2015). Fundamentals of financial management. 6th ed. Fort
Worth: Dryden Press.
Choudhry, M. (2004). An introduction to credit derivatives. Amsterdam: Elsevier.
Fabozzi, F. and Kothari, V. (2008). Introduction to securitization. Hoboken, N.J.: John Wiley
& Sons.
Gottesman, A. and Bossu, S. (2016). Derivatives Essentials. Somerset: Wiley.
Lasher, W. (2016). Practical financial management. Mason, Ohio: Thomson/South-Western.
