Credit Analysis Models Flashcards
What is credit spread?
- Credit Spread:
1. Difference between corporate bond yield and government bond yield of the same maturity.
2. Compensates investors for default risk.
What is expected exposure to default loss?
- Maximum possible loss if default occurs, Includes principal + coupons.
What is recovery rate, loss severity, and loss given default formula?
- Recovery rate: % recovered if default occurs
- Loss severity: 100% - recovery rate
- Loss given default = Loss severity × Bond’s exposure.
What is probability of default?
- Measures likelihood of issuer failing to meet obligations.
What is difference between risk neutral probabilities & actual default probabilities?
- Risk-neutral probabilities: discounts cash flows using risk-free discount rates, risk free discount rates tend to be higher than actual historical default rates
- Actual default probabilities: discounts cash flows using risk-adjusted discount rates and exclude risk premiums.
What is credit value adjustment (CVA)?
- different factors that can be used to determine the present value of the expected losses from default in each year, which can be summed to determine the credit valuation adjustment (CVA)
What are the formulas for CVA or present value of expected losses?
PVEL = discount factor * (expected loss)
PVEL = discount factor * (loss given default * probability of default)
PVEL = discount factor * (exposure * loss severity) * probability of default
PVEL = discount factor * (exposure * loss severity) * (POS * hazard rate)
What are the discount factors in CVA?
1 / (1+ spot curve rate)^n
What is loss severity formula for CVA?
value of bond - recovery rate
What is exposure for CVA?
- present value of bond. bond price discounted to PV.
What is POS and hazard rate in CVA?
POS = probability of survival
hazard rate = likelihood of an event occurring, given that it has not already happened
What is CVA for multiple year bonds?
- sum of PVEL for each year of the bond
What is fair value of bond using CVA?
fair value = default free value - CVA
How do you determine the yield from CVA?
fair value = 100/ (1+yield) ^n
n = length of bond
What is credit spread from CVA?
credit spread = yield - risk free rate
What are a few factors that influence an individuals credit rating?
- Payment history
- Debt burden
- Length of credit history
- Types of credit used
- Recent searches for credit
What’s the difference between credit rating and credit score?
- Credit scores: Used for individuals and small businesses.
- Credit ratings: Used for corporations and governments.
How do major credit rating agency’s assign ratings?
-assign ratings based on default probability
What is a company’s issuer rating based on?
rating is based on company’s senior unsecured debt
What is a transition matrix?
- transition matrix: tool that can be used to illustrate the probability of moving from one rating to another over a year.
What is the magnitude of spread changes on upgrades in debt rating vs downgrades in debt rating?
- Spread increases (from downgrades) are usually larger than spread decreases (from upgrades).
What is structured model and 3 assumptions?
- Structural models seek to explain why defaults occur. based on the assumption that:
- company will default if the value of the liabilities exceeds the value of its assets.
- probability of default has the features of an option. (i.e. debtholders are viewed as owning the assets of company & having written call option to the equity holders, if no default occurs, debtholders will receive strike price equal to the face value of debt. If a default does occur, the equity holders will receive the value of any remaining assets.
- underlying assets are actively traded.
What is reduced form models?
- Reduced-form models seek to identify when a default is likely to occur.
default is assumed to be an external variable that occurs randomly.
What 3 premiums does the benchmark yield include?
- Expected real interest rate
- Expected inflation
- Compensation for inflation uncertainty
What 4 premiums does credit spreads include?
- Expected losses on defaults
- Liquidity
- Taxation (if applicable)
- Compensation for the uncertainty of default losses
What are covered bonds?
- Covered bonds: debt securities issued by a bank or mortgage institution and collateralised against a pool of assets that, in case of failure of the issuer, can cover claims at any point of time
What are hard bullet covered bonds, soft bullet covered bonds, and conditional pass through covered bonds?
- Hard-bullet covered bond: A default is immediately triggered and bond payments are accelerated if payment is not made according to the schedule.
- Soft-bullet covered bond: Default and payment acceleration are delayed until a new final maturity date.
- Conditional pass-through covered bonds: Convert to pass-through securities after the original maturity date in the event that any payments are missed.
