JUST STARTED 7.5 / 29 - Hedge Funds: Credit Strategies

Question 1

LO 29.1: Demonstrate knowledge of the economics of credit risk.

Answer 1

• Recognize the general characteristics of credit instruments typically traded by hedge funds.
• List and describe types of credit events that may lead to an increase in credit risk, and define exposure at default (EAD) and loss given default (LGD).
• Define adverse selection and moral hazard, and describe how they relate to credit risk.
• Discuss how probability of default (PD) and recovery rate (RR) affect credit risk, and calculate loss given default and expected loss from credit risk

Question 2

Credit events include:

Answer 2

• Bankruptcy refers to the dissolution or insolvency of an entity when it is unable to meet its obligations.
• Credit downgrade refers to a rating downgrade by a credit rating agency.
• Failure to make payments in a timely manner arises when a borrower fails to make scheduled principal or interest payments, even if it is not in bankruptcy or in distress.
• Corporate events describe events including mergers or spinoffs, which could weaken an entity’s financial condition and capacity to service its obligations.
• Government actions describe actions including capital controls or restrictions by governments.

Question 3

WHare are the critical measures for measuring credit risk?

Answer 3

• Exposure at default (EAD) measures a creditor’s potential loss if a credit event occurs.
• Loss given default (LGD) measures the loss (and therefore recovery) in a default scenario. LGD is typically less than EAD.
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Question 4

adverse selection & Moral hazard

Answer 4

• Borrowers often have more information than lenders, which is referred to as adverse selection. Adverse selection raises a lender’s risk.
• Adverse selection arises before completion of a financial transaction. In contrast, moral hazard arises after completion of a financial transaction.
• Moral hazard arises when the borrower takes on more risk knowing that the counterparty (lender) bears the risk of the transaction.

Question 5

Probability of default (PD)

Answer 5

refers to the probability that the borrower will not meet its contractual obligations.

Both moral hazard and adverse selection affect PD. Lenders use their expertise, credit spread data, and historical data to gauge PD. Lenders often use credit ratings and credit models to estimate PD. A historical observation that 0.05% of Ba2 firms default would imply that a bond rated Ba2 would have a 0.05% chance of default within the next year.

Question 6

Recovery Rate (RR)

Answer 6

Ties the EAD and LGD together, and is measured as the % of EAD that can be recovered. Note however that a recovery rate of 70% does not necessarily guarantee that the lender will recover 70% of its loan at the time of default. The recovery process can be lengthy and therefore the more relevant measure is the present value of the recovered amount:

recovery rate = present value of recovered sum / EAD

Question 7

Formula for Expected Credit Loss

Answer 7

LGD, EAD, PD, and RR are all related and can be used together to calculate the expected credit loss:

LGD = EAD × (1 – RR)

and

expected credit loss = LGD × PD = EAD × (1 – RR) × PD

Where:

LGD: Loss Given Default
EAD: Exposure at Default
RR: Recovery Rate
PD: Probability of Default.

Question 8

LO 29.2: Demonstrate knowledge of credit risk modeling.

Answer 8

• Describe the basic concepts of credit risk modeling, including the difference between sovereign and higher-levered entities, the related effects of credit risk, and credit risk modeling approaches.

Question 9

Three Primary types of Credit Risk Models

Answer 9

1. Structural Credit Risk Models - draws an explicit relationship between capital structure and default from perspective of equity owner. Within the cap’l structure, value of assets equals the value of equity plus debt, where equity is modeled as a call option on the entity’s assets with a strike price equal to face value of the bonds. Bondholders have a risk-free bond and a short position in a put option on the entity’s assets.
2. Reduced-form Models - These models view default as a random external factor. The models therefore view default as a random event that can be quantified using economic and statistical models.
3. Empirical models. The empirical approach to credit risk modeling does not directly evaluate the entity or its surroundings given the difficulty in forecasting risk factors. Instead, empirical models produce a credit score that is used to rank entities by creditworthiness.

Question 10

LO 29.3: Demonstrate knowledge of the Merton model.

Answer 10

• Apply the Merton model to determine equity values and payoffs to
bondholders for a given investment.
• Use the Black-Scholes option pricing model in the Merton model to price a given firm’s equity as a call option on the stock of the underlying company.
• Use the Black-Scholes option pricing model in the Merton model to price a given firm’s debt as a put option on the stock of the underlying company.
• Analyze the role of credit spreads in structural models and how the credit spread can be used to calculate the price of risky debt.
• Evaluate advantages and disadvantages of the Merton model. • Discuss four important properties of the Merton model.