R.37 Credit Analysis Models

Question 1

CA - PV of Expected Loss

Present Value of Expect Loss

Answer 1

Question 2

Reduced Form Model

(credit analysis)

• assumptions
• strengths/weaknesses

Answer 2

Assumptions

• Key variables: Default Time and Default Intensity.
• ZeroCpn included in Debt, BUT its not the only debt like Structural!
• Risk-free Rate is stochastic (randomly determined)
• State of Economy is stochastic depending on nonconstant macroeconomic variables.
  
  • ​hence business cycles change and probability of default is not contact

​​Strengths

• inputs estimated w/ historical data
• credit risk fluctuates w/ business cycles
• company’s B/S details not required

Weaknesses

• past market conditions market conditions may not reflect future.
• estimates derived from historical data may be inappropriate.

Question 3

Structural credit models

• Assumptions
• Strengths
• Problems
• Implications

Answer 3

Assumptions

1. Assets traded within firm (required by Black Scholes but disadvantage as credit model b/c doesn’t really happen)

2. Simple Balance Sheet (B/S): ZeroCpn Debt_{(only one-class)​} + Equity

Strengths

• Option pricing theory provides
  1. Probability of default and
  2. Loss given default

Problems

• 1. Guess work (callibration w/ 5 variables!)
• 2. Silly B/S (balance sheet = bullshit)
• 3. No Business cycle considerations

Implications

Equity viewed as:

• call option on the assets with a strike price equal to the face value of the debt.
• a long position in the assets, long put option, and short bond.

Debt viewed as:

• writing call options to equity holders.
• long bond and a​ short put