Harvard Case - Credit Default Swaps on AMR Corporation: Cash or Credit?
"Credit Default Swaps on AMR Corporation: Cash or Credit?" Harvard business case study is written by Pedro Matos, Peter Lee. It deals with the challenges in the field of Finance. The case study is 7 page(s) long and it was first published on : Mar 9, 2016
At Fern Fort University, we recommend that AMR Corporation, the parent company of American Airlines, should not proceed with the proposed credit default swap (CDS) transaction. The potential benefits of the CDS, including hedging against potential credit risk, are outweighed by the significant risks associated with the transaction. Instead, AMR should focus on improving its financial position through cost-cutting measures, revenue generation initiatives, and strategic debt management. This approach will provide a more sustainable and less risky path to financial stability.
2. Background
AMR Corporation, the parent company of American Airlines, was facing significant financial challenges in 2008. The airline industry was undergoing a period of intense competition and economic downturn, leading to declining revenues and profitability. AMR's financial statements reflected this strain, with high debt levels and a declining credit rating.
The case study focuses on AMR's consideration of a credit default swap (CDS) transaction. The CDS would have provided protection against potential credit risk, but at a significant cost. The main protagonists of the case are:
- AMR management: Facing the pressure of improving the company's financial position and seeking ways to mitigate risk.
- Financial advisors: Providing advice on the potential benefits and risks associated with the CDS transaction.
- Investors and creditors: Concerned about AMR's financial health and the potential impact of the CDS on the company's creditworthiness.
3. Analysis of the Case Study
The case study can be analyzed through the lens of Financial Strategy, focusing on Risk Management, Debt Management, and Capital Structure.
Financial Analysis:
- High Debt Levels: AMR's financial statements reveal a high level of debt, putting pressure on the company's cash flow and increasing its vulnerability to economic downturns.
- Declining Credit Rating: The company's declining credit rating reflects investor concerns about its financial health, making it more expensive to borrow money.
- CDS Potential: The CDS offers a potential hedge against credit risk, but the cost of the protection is significant and could further strain the company's finances.
Risk Assessment:
- Counterparty Risk: The CDS transaction exposes AMR to counterparty risk, meaning the risk that the financial institution providing the CDS may not be able to fulfill its obligations.
- Market Risk: The value of the CDS can fluctuate significantly based on market conditions, potentially leading to large losses for AMR.
- Reputation Risk: The decision to enter into a CDS transaction could damage AMR's reputation among investors and creditors, further impacting its financial position.
Capital Structure:
- Debt Financing: AMR's reliance on debt financing exposes it to higher financial risk, making it more vulnerable to economic downturns.
- Equity Financing: While equity financing can reduce debt levels, it can dilute existing shareholders' ownership and potentially impact the company's control.
4. Recommendations
- Reject the CDS Transaction: The risks associated with the CDS transaction outweigh the potential benefits. The high cost of the protection, counterparty risk, and market risk make it an unwise investment.
- Focus on Cost-Cutting Measures: AMR should implement a comprehensive cost-cutting program to improve its profitability and cash flow. This could include reducing operating expenses, renegotiating contracts, and streamlining operations.
- Increase Revenue Generation: AMR should explore new revenue streams and initiatives to increase its top-line growth. This could include expanding into new markets, developing new products and services, and leveraging technology to improve efficiency and customer experience.
- Strategic Debt Management: AMR should actively manage its debt portfolio, prioritizing debt reduction and seeking refinancing opportunities to lower interest costs.
- Improve Transparency and Communication: AMR should improve its communication with investors and creditors, providing clear and concise information about its financial position and future plans.
5. Basis of Recommendations
- Core Competencies and Consistency with Mission: The recommendations focus on improving AMR's financial performance, which is essential for the company's long-term success and aligns with its mission of providing safe and reliable air travel.
- External Customers and Internal Clients: The recommendations aim to improve the company's financial health, which will benefit both external customers and internal clients by ensuring the company's long-term sustainability.
- Competitors: The recommendations will help AMR compete more effectively in the airline industry by improving its financial position and operational efficiency.
- Attractiveness ' Quantitative Measures: While specific quantitative measures are not provided in the case study, the recommendations are expected to improve AMR's profitability, cash flow, and credit rating, making it more attractive to investors and creditors.
6. Conclusion
AMR Corporation should prioritize a comprehensive approach to improving its financial position, focusing on cost-cutting, revenue generation, and strategic debt management. The proposed CDS transaction presents significant risks and should be rejected. By focusing on these key areas, AMR can achieve sustainable financial stability and improve its long-term prospects.
7. Discussion
Other Alternatives:
- Equity Financing: While equity financing could reduce debt levels, it could also dilute existing shareholders' ownership and potentially impact the company's control.
- Asset Sales: Selling off non-core assets could generate cash flow, but it could also weaken the company's competitive position.
Risks and Key Assumptions:
- Economic Recovery: The recommendations assume a gradual economic recovery, which could impact the effectiveness of cost-cutting and revenue generation initiatives.
- Competition: The recommendations assume that AMR can effectively compete in the airline industry, despite ongoing competitive pressures.
- Execution: Successful implementation of the recommendations requires strong leadership and effective execution, which could be challenging in a difficult economic environment.
8. Next Steps
- Develop a comprehensive cost-cutting plan: Identify areas for expense reduction and implement measures within the next 6 months.
- Initiate revenue generation initiatives: Explore new markets, products, and services within the next 12 months.
- Reassess debt portfolio and seek refinancing opportunities: Implement a debt management strategy within the next 6 months.
- Enhance transparency and communication with investors and creditors: Improve communication channels and provide regular updates on the company's financial performance.
By implementing these recommendations and taking a proactive approach to managing its finances, AMR Corporation can overcome its current challenges and position itself for long-term success.
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Case Description
This case puts the students in the shoes of Jeff Thomas, a high-yield credit research analyst for a hedge fund. Thomas' portfolio manager has asked him to come up with a potential trade idea for AMR Corporation (the parent company of American Airlines) using a credit default swap (CDS). Thomas wanted to gauge whether the CDS spread prevailing in the market was too high or too low relative to AMR's credit outlook. He was going to use both structural and reduced form CDS pricing models and compare them against the prevailing CDS spreads in the market. More importantly, Thomas needed to come up with a trade recommendation.
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