Fixed Income: Credit Analysis Models

Question 1

Loss Given Default / Recovery Rate

Answer 1

• Loss given default: overall position (remaining coupon + Principle) that would be lost
• Recovery rate: The remaining amount after LGD is taken out.

Question 2

Credit Risk: Expected Loss

Answer 2

= Probability of Default X Loss Given Default

Question 3

PV of Expected Loss: Credit Risk

Answer 3

• Highest fee holder would pay to remove the risk of the bond
  1. Risk neutral probabilities are used instead of actual probs like expected loss
• 2. time value of money is considered*

Question 4

Credit Evaluation Models

Answer 4

1. Credit ratings: Consistency over accuracy
2. Structural models: Options based with unrealistic expectations
3. Reduced Form Models: Variable Rf%, economic factors, etc.