Credit Analysis Models Flashcards
What is the present value of expected loss?
Conceptually largest price one would be willing to pay on a bond to a third party to remove the credit risk while holding the bond.
It s the most complex and important credit risk measure It involves two mods to the expected loss:
The first modification is to explicitly adjust the probabilities to account for the risk of the cash flows ( risk premium).
The second modification is to include the time value of money in the calculation- that is, the discounting of the future cash flows to the present.
It is the most important credit risk measure followed by expected loss and finally probability of default.
Credit Scoring and Ranking
The two traditional approaches to credit risk analysis. Ordinal ranking because only order borrowers riskiness from highest to lowest.
Credit scoring is used for small owner-operated businesses and individuals.
Credit ratings are used for companies, sovereigns, sub-sovereigns, and those entities’ securities, as well as asset-backed securities.
Credit Scoring features
Credit scoring ranks a borrower’s credit riskiness it does not provide an estimate of a borrower’s default probability
- It does not explicitly depend on current economic conditions
- It is not the percentile ranking of the borrower among a universe of borrowers
- It has different implications for the probability of default depending on the borrower and the nature of the loan that has been extended
- There is emphasis on credit scoring stability over time
Strength of Credit Ratings
Simplicity
Stability
Weaknesses of Credit Ratings
Inconsistent link with default probability
No explicit link with the business cycle
Compensation system with potential conflict of interest that may distort the accuracy of credit ratings.
Structural Model Aims
Aims to understand the economics of a company’s liabilities and build on the insights of option pricing theory. Assumes a simple balance sheet consisting of a single liability, a zero-coupon bond. Equity can be viewed as euro call option on the assets with strike price = face value of debt.
Strength of Structural Models
Optional analogy of a company’s default probability and recovery rate
Estimated using current market prices
Weaknesses of structural models
Balance sheets hard to model
firm’s asset value is un-observable
inherit errors in the model’s formulation
business cycles are not taken into account
Reduced Form Models
Originated to overcome a key weakness of the structural Model- the assumption that the company’s assets trade. This assumption is replaced with a more robust one- that some of the company’s debt trades.
They are called reduced form models because they impose their assumptions on the outputs of a structural model- probability of default and loss given default rather than on the balance sheet structure itself.
This allows RFM flexibility in matching actual market conditions
Implicit Approach to estimate model parameter
Used for both structural and reduced form models. One must completely specify the inputs to the model and the probability distributions for the macroeconomic state variables.
Historical Approach to estimate model parameter
Only for reduced form because the economy’s macro state variables and the company’s debt prices are both observable. Estimating a reduced form models parameters using historical estimation is an application of hazard rate estimation.
Strength of Reduced Form Models
The model inputs are observable
Business cycle is taken into account
No need for specification of balance sheet structure
Weaknesses of Reduced Form Models
Hard to properly formulate the model and back test it
Term structure of credit spreads
Corresponds to the spread between the yields on default-free and credit risky zero-coupon bonds.
Structural or RFM under frictionless market assumption assumes credit spread is entirely due to credit risk.
Credit spread is equal to the difference between the average yields on the risky zero-coupon bond and the riskless zero-coupon bond.
Asset backed securities
ABS is a type of bond issue by a legal entity called a SPV
SPV is created by equity holders to finance the purchase of the collateral pool and the equity holders issue debt.
Asset side owns collection of collateral pool. liability side owes senior bond tranche, mezzanine bond tranche, junior bond tranche.
