Class 3: Credit Risk

Question 1

What is Market for Credit composed of?

Answer 1

Question 2

credit demand for operating Activities?

Answer 2

Question 3

credit demand for investing activities?

Answer 3

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

Question 4

Credit Demand for Financing Activities?

Answer 4

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

Question 5

What are the sources of credit to meet companies demand?

Answer 5

non bank financing

bank loans

trade credit

publicly traded debt

lease financing

Question 6

what is trade credit

Answer 6

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

Question 7

what are bank loans? how are they important?

Answer 7

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

Question 8

what is non banking financing?

Answer 8

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

Question 9

characteristics of lease financing?

Answer 9

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

Question 10

what is publicly traded debt?

Answer 10

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

Question 11

what is the credit risk analysis process?

Answer 11

Question 12

what are credit raters?

Answer 12

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

Question 13

do default probabilities increase with time?

Answer 13

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

Question 14

what are Hazard Rates and Unconditional Default Probabilities?

Answer 14

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

Question 15

what is a recovery rate?

Answer 15

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

Question 16

what does risk free rate mean?

Answer 16

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

Question 17

what are Real World vs Risk-Neutral Default Probabilities?

Answer 17

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

Question 18

which world should we use (real world vs Risk Neutral)?

Answer 18

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

Question 19

what is/are the Risk-Neutral Assumptions?

Answer 19

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.

Question 20

features of a risk neutral world?

Answer 20

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.

Question 21

what are the consequences of a risk neutral world?

Answer 21

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.

Question 22

what is Mertons model when using equity prices?

Answer 22

Question 23

what is the process of implementation of Merton’s model?

Answer 23

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.

Question 24

what are the three cases of credit risk in derivative transactions?

Answer 24

Three cases
Contract always an asset
Contract always a liability
Contract can be an asset or a liability

Question 25

what is default correlation?

Answer 25

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.

Question 26

what is the Gaussian Copula Model?

Answer 26

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