Class 3: Credit Risk Flashcards
What is Market for Credit composed of?
credit demand for operating Activities?
credit demand for investing activities?
Require large amounts of cash for investments such as new equipment or mergers
Needs can vary in timing and amount
Long-term debt routinely used for start-up
and growth
Predictable capital expenditure patterns often held by mature firms
Credit Demand for Financing Activities?
Occurs less frequently than operating and investing activities
Common situations
A bank loan or bond comes due and a
company does not have the necessary
funds on hand
Funds to pay dividends or repurchase
stock are borrowed Evergreen debt
When a company consistently pays off
debt by taking on more debt
What are the sources of credit to meet companies demand?
non bank financing
bank loans
trade credit
publicly traded debt
lease financing
what is trade credit
Routine credit from suppliers
Most often non-interest bearing
Suppliers often tailor contractual terms to particular customer’s existing and ongoing creditworthiness
Credit limit assigned
what are bank loans? how are they important?
Structured to meet specific client needs
Balanced with myriad of rules and
regulations by bank regulators
Revolving credit line
Available on demand
Floating interest rate
Lines of credit
Available credit to be used as needed
Letters of credit
Financing feature where a bank is
interposed between two parties
Term loans
A set loan amount (principal) with specified
periodic payments
Interest rates are either fixed or floating
for the duration of the loan Mortgages
Debt instruments based on collateral,
typically, real estate holdings
what is non banking financing?
Private (nonbank) sources of financing used when bank financing is limited or unavailable.
Results from private lenders such as
private equity firms that have experience
in industry
Private lenders creatively structure loan
repayment and may act as a
management consultant
characteristics of lease financing?
Typically used for the acquisition of capital equipment.
Typical items
Machinery
Computer equipment
Vehicles
Leasing firm structures lease
Considers collateral
Credit risk of the lessee
what is publicly traded debt?
Debt capital raised through public markets.
Commercial paper
Short-term borrowing resource under SEC
regulations which cannot exceed 270 days
Bonds or debentures
Public borrowings for longer durations
regulated by the SEC
Principal borrowed is paid back on a fixed
term with semi-annual or annual interest
payments
what is the credit risk analysis process?
what are credit raters?
Credit rating agencies assess credit risk
Differ from other lenders
Have no direct financial involvement with
companies whose credit they are rating
Have access to more, better, and most
current information
Can refine risk analysis across industries
do default probabilities increase with time?
For a company that starts with a good credit rating default probabilities tend to increase with time
For a company that starts with a poor credit rating default probabilities tend to decrease with time
what are Hazard Rates and Unconditional Default Probabilities?
The hazard rate (also called default intensity) is the probability of default for a certain time period conditional on no earlier default
The unconditional default probability is the probability of default for a certain time period as seen at time zero
what is a recovery rate?
The recovery rate for a bond is usually defined as the price of the bond immediately after default as a percent of its face value
Recovery rates tend to decrease as default rates increase
what does risk free rate mean?
The risk-free rate when default probabilities are estimated is usually assumed to be the LIBOR/swap zero rate (or sometimes 10 bps below the LIBOR/swap rate)
Asset swaps provide a direct estimates of the spread of bond yields over swap rates
what are Real World vs Risk-Neutral Default Probabilities?
The default probabilities backed out of bond prices or credit default swap spreads are risk-neutral default probabilities
The default probabilities backed out of historical data are real-world default probabilities
which world should we use (real world vs Risk Neutral)?
We should use risk-neutral estimates for valuing credit derivatives and estimating the present value of the cost of default
We should use real world estimates for calculating credit VaR and scenario analysis
what is/are the Risk-Neutral Assumptions?
The risk-neutral assumption is a foundational concept in financial economics, particularly in the pricing of derivatives and the valuation of financial assets.
This assumption posits that when valuing assets, investors are indifferent to risk. That is, they do not demand a higher expected return for taking on more risk, contrasting with the real-world scenario where most investors are risk-averse and require higher returns to compensate for higher risk.
features of a risk neutral world?
The expected return on a stock (or any other investment) is the risk-free rate.
The discount rate used for the expected payoff on an option (or any other instrument) is the risk-free rate.
what are the consequences of a risk neutral world?
The world we live in is, of course, not a risk-neutral world. The higher the risks investors take, the higher the expected returns they require. However, it turns out that assuming a risk-neutral world gives us the right option price for the world we live in, as well as for a risk-neutral world.
By assuming risk neutrality, complex financial models, especially those for derivatives pricing (like the Black-Scholes model), become mathematically tractable. It allows for the straightforward application of probabilistic methods to value options and other derivatives.
what is Mertons model when using equity prices?
what is the process of implementation of Merton’s model?
Choose time horizon
Calculate cumulative obligations to time horizon. This is termed by KMV the “default point”. We denote it by D
Use Merton’s model to calculate a theoretical probability of default
Use historical data or bond data to develop a one-to-one mapping of theoretical probability into either real-world or risk-neutral probability of default.
what are the three cases of credit risk in derivative transactions?
Three cases
Contract always an asset
Contract always a liability
Contract can be an asset or a liability
what is default correlation?
The credit default correlation between two companies is a measure of their tendency to default at about the same time
Default correlation is important in risk management when analyzing the benefits of credit risk diversification
It is also important in the valuation of some credit derivatives, eg a first-to-default CDS and CDO tranches.
what is the Gaussian Copula Model?
Define a one-to-one correspondence between the time to default, ti, of company i and a variable xi by
Qi(ti ) = N(xi ) or xi = N-1[Q(ti)]
where N is the cumulative normal
distribution function.
This is a “percentile to percentile” transformation. The p percentile point of the Qi distribution is transformed to the p percentile point of the xi distribution. xi has a standard normal distribution
We assume that the xi are multivariate normal. The default correlation measure, rij between companies i and j is the correlation between xi and xj
