Credit Analysis Models Flashcards
Default risk
Likelihood of default event
Default risk preimium
Reflects uncertainty in timing of default
Credit Risk
Given Default, how much is likely to be lost?
L.G.D - Loss Given Default
LGD Formula = Expected Exposure X Loss sensitivity
Expected Exposure
The amount of money that could be lost in default without consdidering recovery
Example: 1 year 4% bond at par - EE = 104
Recovery Rate
% of recovered in default
Loss severity
1 - RR
Formula for Probability of Default (POD) at time n
(Probability of survival at n-1) x (Probability of default)
Formula for Expected loss
LGD x PODn
[EE(1-RR)] x [Pos n-1 x POD]
Credit analysis of securitized debt: Homogenity
THINK OF SIMILARITY
Degree to which the underlying debt characteristics are similar across individual obligations.
Homogenity: General concluion from the class.
Hetrogenity: Security on a loan by loan basis
Credit analysis of securitized debt: Granularity
Actual number of obligations in the structural security
Many: Conclusion based on summary statistics
Few: Analysis of each individual secuirty.
Credit analysis of securitized debt: Organation and Secuicing
Exposure to operational counterparty risk over the life of the securitized asset.
Credit analysis of securitized debt:
Structure of the secured debt transaction
SPV + Any strucutural enhancement
What is Credit Scores?
Retail lending market
Ranks a borrowers credit riskiness from highest to lowest.
Does not provide estimate of a borrowers default probability.
It is called an ordinal ranking because it only orders borrowers riskiness from highest to lowest.
Does not depend on economic conditions
What is Credit rating?
Wholesale lending market. Ranks credit risk of a company, government, or ABS.
Risk Neutral Probability
FV = [ND(1-P) + DxP] / 1+rfr
**Best way to conceieve Risk neutral probabilities of default **: The historical probability of default + premium for the uncertainty of the timing of default.
How to calculate expected return from credit migration
Expected rate of return due to credit migration
-ModDur x (New Credit spread - Old Credit Spread)
Probability of default for year n
POS ^(n-1) x POD
What is the relationship between credit spreads and benchmark spread in regards to each other and the business cycle.
Negative and Counter cyclical.
A stronger economic climate is generally associated with higher benchmark yields but lower credit spreads reflecting lower POD.
Credit spreads have a negative relastionship with benchmark rates - Contracting as rates ris and expanding as rates drop.
And Countercyclical with the business cycle - narrowing as the economy expands and widening as the economy contracts.
A 3 year 10% annual corporate bond has a VND of 125.0193 and a CVA of 6.0389. What is the credit spread if the 3 year par rate is 1.5% ?
Step 1. VND - CVA = Present value of bond
125.0193 - 6.0389 = 118.9804
Type in the values in the calculator, solve for YTM
YTM = 3.2567
Credit spread = YTM - Par rate = 1.7567% = 176 Bsp
How do we measure/determine the credit riskiness of a bond?
By calculating expected loss
LGD x POD
EE(1-rr) x POS^n-1 x POD
Structure model, when does a company default?
Company defaults on its debt when the value of assets falls below the value of liability
Formula for Loss Given Default
EE x (1-RR)
What relationship does CVA have with change in interest rates?
Inverse relationship.
Increasing interest rates -> Lower CVA
Decreasing interest rates -> Higher CVA
Since rates tend to drop during a recession, all forward rates in the tree will be lower, leading to higher EE at each time node. Therefore LGD increases.
Formula for CVA
LGD x POD x Discount Factor
LGD x POD / (1+R)^t
The CVA is the sum of the present value of expected losses on the bond
Which is the best way to conceive of the Risk Neutral probability of Default
The Historical Probability of Default + Premium for the uncertainity of timing the default
