Credit Analysis Models

Question 1

Default risk

Answer 1

Likelihood of default event

Question 2

Default risk preimium

Answer 2

Reflects uncertainty in timing of default

Question 3

Credit Risk

Answer 3

Given Default, how much is likely to be lost?

L.G.D - Loss Given Default

LGD Formula = Expected Exposure X Loss sensitivity

Question 4

Expected Exposure

Answer 4

The amount of money that could be lost in default without consdidering recovery

Example: 1 year 4% bond at par - EE = 104

Question 5

Recovery Rate

Answer 5

% of recovered in default

Question 6

Loss severity

Answer 6

1 - RR

Question 7

Formula for Probability of Default (POD) at time n

Answer 7

(Probability of survival at n-1) x (Probability of default)

Question 8

Formula for Expected loss

Answer 8

LGD x PODn

[EE(1-RR)] x [Pos n-1 x POD]

Question 9

Credit analysis of securitized debt: Homogenity

Answer 9

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

Question 10

Credit analysis of securitized debt: Granularity

Answer 10

Actual number of obligations in the structural security

Many: Conclusion based on summary statistics

Few: Analysis of each individual secuirty.

Question 11

Credit analysis of securitized debt: Organation and Secuicing

Answer 11

Exposure to operational counterparty risk over the life of the securitized asset.

Question 12

Credit analysis of securitized debt:
Structure of the secured debt transaction

Answer 12

SPV + Any strucutural enhancement

Question 13

What is Credit Scores?

Answer 13

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

Question 14

What is Credit rating?

Answer 14

Wholesale lending market. Ranks credit risk of a company, government, or ABS.

Question 15

Risk Neutral Probability

Answer 15

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.

Question 16

How to calculate expected return from credit migration

Answer 16

Expected rate of return due to credit migration

-ModDur x (New Credit spread - Old Credit Spread)

Question 17

Probability of default for year n

Answer 17

POS ^(n-1) x POD

Question 18

What is the relationship between credit spreads and benchmark spread in regards to each other and the business cycle.

Answer 18

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.

Question 19

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% ?

Answer 19

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

Question 20

How do we measure/determine the credit riskiness of a bond?

Answer 20

By calculating expected loss

LGD x POD

EE(1-rr) x POS^n-1 x POD

Question 21

Structure model, when does a company default?

Answer 21

Company defaults on its debt when the value of assets falls below the value of liability