Ch7 - Alternative Estimations of Credit Quality

Question 1

Evolution of Expected Default Frequencies (EDFs)

Answer 1

According to MM: if the MV of the firm’s assets is below the MV of the firm’s debt at maturity, the call option is worthless, since the strike price is the value of debt.

• If we could model which firms are likely to have the value of their assets fall below the value of their debt, we would know which firms are likely to default
• In the 1980s, KMV came up with its own version of the MM based on historical data of defaulted companies and was able to sell their product, as a default probability. This EDF system was bought by Moody’s in 2002

Question 2

Pros and Cons of EDFs

Answer 2

• Pros: neutral numerical estimation with a forward-looking view (based on MV); bridge between the credit and equity markets, and therefore benefit from collective judgment; up-to-the minute information
• Cons: calculations not transparent to users; many companies with high default frequencies can still survive for a while; relies on the BV of debt; are volatile; only works for publicly traded companies

Question 3

What is a Credit Default Swap?

Answer 3

CDSs can be thought of as insurance against credit risk (although it is a derivative transaction)

• Purchases of CDSs buy protection against the risk of default of an entity. If the entity defaults, the CDS buyer receives a certain amount of money from the CDS seller
• CDS prices can reflect buyers and sellers views on the creditworthiness of an entity: the higher the perceived credit risk, the higher the price of the CDS

Question 4

How are CDS prices used to measure credit risk?

Answer 4

• Prices react to overall macroeconomic conditions, going up when the economy slows, and down when conditions improve.
• CDSs react quickly to market news and reflect the instant view of capital market participants on a company (early warning system). Prices move so quick because the transactions themselves are so quick because transactions don’t involve funding

Question 5

Limitation of CDS prices

Answer 5

CDSs are viewed as complimentary to ratings, but no institution would rely wholly on them, because:

• Very few entities trade CDSs: mainly dominated by big investment banks
• Some vendors extrapolate information from the CDS market to present implied prices for entities for which a CDS market does exist: assumptions/approximations
• CDS prices can be greatly influenced by noncredit events and be distorted to a point where they don’t reflect default risk