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CapEx Unlimited (CEU), one of Charles Bank International’s (CBI) important clients, asked for $50 million to finance its network expansion. However, the new loan would put CBI over its credit exposure limit. CBIT contacted First American Bank (FAB) to establish a credit default swap, which would mitigate its credit risk from the new loan. What is the probability that CEU will default within two years? In order to accurately price the credit default swap, we need to start with an assessment of credit risk – the probability of default. According to Exhibit 10b, the probability that CEU (rating B2) will default by the end of year 2 is 13.7%. But, this data only reflects historical information, which is not appropriate for derivatives pricing. Therefore, we use Merton Model to calculate CEU’s default probability. The Merton Model proposed by Robert Merton characterizes a company’s equity as writing a call option or buying a put option on the assets of the company with maturity T and a strike price equal to the face value of the debt. The implied volatility from options can be regarded as the expected probability of default. Currently, CEU’s market value of the firm equals to $10,900 million (S0) and the outstanding debt has a maturity of 5 years (T). CEU’s market value of debt is $4,100 million, so its face value of debt should be more than $4,100 million. For treasury STRIP with 5-year maturity (r=4.5% according to Exhibit 8), if its market value is $4,100 million, its face value will be $5109 million. Therefore, it is reasonable to estimate that CEU’s face value of debt is $5,200 million, which equals to option strike price X. If the volatility of equity (sd) is given, then we can easily get the price of option and the probability of default by using the formula below. (See table below an example) P0 = X*e-rt * [1-N(d2)] – S0*[1-N(d1)] Where P(D) = N(-d2)

Black Scholes Calculation Example Exercise Price=Debt Face Value Time to Expiration of Option Volatility of Equity 5 Year STRIP Yield Market Value of Firm P0 116.26 S0 10900 X 5200 r 0.045 T 4 X T sd rf So Sd 0.3 5200 5 30% 4.50% 10900 d1 1.8186 d2 1.2038 N(d1) 0.9655 P(D) N(d2) 0.8857 0.11434

indicating the annual fee payment on a default swap with a notational principal of $1.00% 18.5%.90% 96. At the time of the deal.1894% 0.9753 0.9048 Set total PV of expected loss cost equals to PV of expected swap fee.05% 1. assume we have an accumulated default probability of 10.5 2 Total 1.5 2 Total Expected Fee Payment Discount Factors PV(Expect ed Cost) PV(Expect ed Fee Payment) 1.00% 18.05% 1.9684s 0.1894% 0.089 Swap Fee Rate Calculation The table below shows the cash flows from the swap.9579s PV Expected Cost 0.9790s 0.00% 18.9277 0.05% 1.8667s 3.000.1894% Expected Fee Payment 0.9048 92342 90062 87839 85670 355914 93835 90545 87361 84278 356019 . Then.05% 1.9753 0.00712 PV Expected Fee Payment 0.9895s 0.00% 94680 94680 94680 94680 96210 95187 94165 93142 0.00176 0. The notional amount equals to new loan $50 million with a recovery rate of 82% (Exhibit 14).00% 18. the five-year risk-free rate was 4.9512 0.000 = $196.05% 1. Therefore.00196.52% within 5 years. Annual Swap Fee = 2*s*$50.9512 0.05% 98.9277 0. Expected LGD Cost at Default 18.5 1 1.6310s Year Default Probability Survival Probability Discount Factors 0. As we know.90% 96.79% 0.05% 1.00171 0.Swap Fee Rate Calculation Now.00% 18. in an efficient market.05% 98. The swap fee is paid semiannually coinciding with coupon of the bonds. The calculation below is based on a notational principal of $1.8984s 0.00% 18.631 = 0.00180 0.9312s 0.00712/3. Year Default Probability Suvival Probability LGD Expected Cost at Default 0.5 1 1.95% 97.00% 0.9650s 0.95% 97. which indicates a semiannual default probability of 1.052%. Set swap fee rate as s.79% 18.1894% 0. the cost of loss without swap should equal to fee payments.00185 0.84% 95. s= =0.84% 95.

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