Reading 31: Credit Analysis Models

Question 1

Expected exposure

Answer 1

-the amount of money a bond investor in a credit risky bond stands to lose at a point in time before any recovery is factored in.

Question 2

Recovery Rate

Answer 2

• The percentage recovered in the event of default.

- Is the opposite of loss severity

Question 3

Loss given default

Answer 3

severity x exposure

Question 4

Probability of defaults

Answer 4

likelihood of default occurring in a given year

PDt = hazard tate * PS(t-1)

In the first year, the probability of default = hazard rate . In subsequent years, probability of default < hazard rate

Question 5

Hazard Rate

Answer 5

-conditional probability of default given that defaults has previously not occurred

Question 6

Probability of survial

Answer 6

1 - cumulative probability of default.

-If we assume constant hazard rate, then probability of survival is

PSt = (1 - hazard rate)

**Probability of survival decreases over time

Question 7

Credit Valuation Adjustment

Answer 7

• sum of the present value of the expected loss for each period
• CVA is the monetary value of credit risk in PV terms

CVA = price of risk-free bond - price of risky bond

Question 8

Risk neutral probability of default

Answer 8

-probability of default implied in the current market price

Ex:
1-year, zero coupon, $100 par bond trading at $95…..benchmark 1-year rate is 3% and recover rate is 60%

expected year end cash flow = 60p + 100(1-p) -> 100 - 40p -> 95 = (100-40p)/1.03

p = 5.38%

Question 9

Notching

Answer 9

-lowering the rating by one of more levels for more subordinate debt of an issuer

Question 10

Credit migration

Answer 10

• A change in credit rating generally reflects a change in the bond’s credit risk.
• The change in the price of the bond depends on the modified duration of the bond and the change in spread resulting from the change in credit risk as reflected by the migration.

change in price = -(modified duration of bond) x (change in spread)

Question 11

Structural Models

Answer 11

• structural models of corporate credit risk are based on the structure of a company’s balance sheet and rely on insights provided by option pricing theory.
• assets and liabilities
• default barrier
• require information Best known to the managers of the company

Question 12

Option Analogy

Answer 12

• Shareholder effectively have a call option on the company’s assets with a strike price equal to the face value of debt.
• If at maturity of debt, the value of the company’s assets is higher than that of debt, shareholders will exercise their call options to acquire assets, pay off debt and keep residual. If not, shareholders will let options expire worthless.

Value of equity = max(0, At - K)
Value of debt = At - value of equity
Value of debt = min (At, K)

Question 13

Alternate option analogy view

Answer 13

-investors are long the net assets of the company and long a put option, allowing them to sell assets at exercise price of K
-Default is synonymous with exercising put option:
value of put option = max(0, K-At)

value of risky debt = value of risk-free debt - value of put option
value of risky debt = value of risk-free debt - CVA

Question 14

Adv/Disadv of Structural Models

Answer 14

Adv: structural models provide an economic rationale for default and WHY default occurs, structural models utilized options models to value risky debt
Disadv: not good for complex balance sheets, assumes asset trade in public market

Question 15

Reduced Form Models

Answer 15

• Model WHEN default occurs instead of why…default is considered a random exogenous variable
• Key input into model is default intensity (probability of defaults over the next small time period).
• involves regression analysis using information generally available in the financial markets

Question 16

Reduced form Adv/Disadv

Answer 16

Advantage: do not assume company is traded, default intensity can vary with change in company or economy
Disadvantage: do not explain why default occurs, default is treated as a random even, but in reality it rarely is

Question 17

Credit spread on risky bond

Answer 17

YTM of risky bond - YTM of benchmark

Question 18

Value given no default

Answer 18

-Value of risky bond assuming it does not default

CVA = VND - value of risk debt

Question 19

Expected Exposure

Answer 19

-The amount of money a bond investor in a credit risky bond stands to lose at a point in time before any recovery is factored in.

Question 20

Securitized dent

Answer 20

• financing of specific assets without financing the entire balance sheet usually through bankruptcy remote SPE
• Allows for higher leverage and lower cost to the issuer.

Components:
-collateral pool: homogeneity (similarity of assets in pool), granularity (transparency of assets in pool)
-servicer quality: manages origination and servicing
of collateral pool
-Structure: determines the trancing or other management of credit and other risks in collateral pool.
-look at credit enhancements: internal vs external

Question 21

Internal Enhancements

Answer 21

• tranching of credit risk among classes with different seniority
• overcollateralization
• excess servicing spread

Question 22

External enhancements

Answer 22

• third party guarantees (bank, insurance company, loan originators)
  
  • covered bond: collateral pool backed by issuer