Reading 3.2 Flashcards
5 major credit events
1) Bankruptcy
2) Downgrading of credit rating
3) Failure to make timely payments
4) Corporate events - This refers to events (e.g., mergers or spin-offs) that weaken an entity’s financial condition, making it difficult for the entity to meet its financial obligations.
5) Government actions - This refers to government restrictions (e.g., capital controls) that may prevent a borrower from meeting its obligations.
The degree and effect of credit risk depend on several factors, two of which are
- Exposure at default (EAD) - This refers to a creditor’s potential loss resulting from a credit event.
- Loss given default (LGD) - This takes into account potential recovery in the event of default.
Adverse selection refers to
an economic process in which undesirable outcomes occur when parties to a transaction have asymmetric information (before a financial transaction is completed).
Akerlof (1970) describes a market with asymmetric quality information as a
“market for lemons”, using the slang word lemon to refer to a defective or faulty item
Akerlof explains that the implication of asymmetric information
between sellers and potential buyers is that ____
Give an example of high quality and low quality cars
As an example of what do economists use the market of lemons?
the quality of goods in a market declines:
poor quality cars drive high-quality cars from the market. This is because buyers, concerned that a car is of poor quality, will not a pay high price for it; and sellers will not sell high-quality cars
Consequently, economists use markets for lemons as an example of potential market failure.
Describe Moral hazard
occurs after an economic transaction is completed and arises when one party to a transaction changes its behavior (e.g., assumes more risk) and the other party bears the consequences.
To reduce moral hazard, lenders can do what?
monitor borrowers’ behavior, restrict how loans’ proceeds may be used, and limit the size of loans to risky borrowers.
borrower’s PD is affected by
firm-specific and macroeconomic conditions,
and can be reduced by mitigating the effects of adverse selection and moral hazard.
Lenders use what to attain accurate estimates of the PD?
market data, credit ratings (current and historic), and experience (credit spreads)
Some credit risk models improve their estimates of PD using market data such as credit spreads (i.e., high yields on credit risky instruments given to lenders).
Some lenders improve their PD estimates using historical credit ratings from external rating agencies. For instance, if, historically, 0.1 % of AAA-rated firms have defaulted on their loans and this figure is relatively stable, the
current rating of a AAA bond can be used to estimate its PD as 0.1 %.
PD
Probability of Default
The recovery rate (RR) is
the percentage of EAD that may be recovered after default.
LGD may be expressed in terms of RR as:
LGD = EAD x (1-RR)
EAD may be expressed as the
Principal + Interest Due
RR is calculated using the _____ of the recovered amount and may be expressed as
present value
expected loss from credit risk may be expressed as
E[Loss] = LGD x PD = EAD x (1-RR) x PD
Most often owners of government bonds (e.g., U.S. Treasuries) are exposed to ____ risk, but not ___ risk
interest rate
credit
Credit risk models can be used to assess credit-based instruments to determine what?
Based on this, investors can do what?
Most credit risk models assume that default is ____.
1) whether their relative prices are correct
2) take positions in the instruments
3) an end point
There are three types of credit risk modeling approaches
- Structural approach
- Reduced-form approach
- Empirical approach
Describe the Structural approach to credit risk modeling
How does it describe the value of the firms assets?
Firms equity is considered as?
Firms debt is considered as?
Assumes an explicit relationship between a firm’s capital structure and default
Describes the value of a firm’s assets as being equal to the value of its equity plus the value of its debt.
► The firm’s equity is considered a call option on its assets, with a strike price equal to the face value of its debt due at exercise date.
► The firm’s risky debt is considered a risk-free bond and a short position in a put option on the firm’s assets. If the assets’ value is less than the debt’s face value, the put option will be exercised on the bondholders, resulting in their giving up the risk-free bond and receiving the firm’s assets.
Describe the Reduced-form approach to credit risk modeling
These models assume that default is a
models default as an random event driven by a random occurance, the behavior of which is the deciding factor of default.
random event that may be described using statistical and economic models.
Describe the Empirical approach to credit risk modeling
Based on this, the approach generates a ___ that is used to?
does not attempt to model companies. Instead, the approach examines the financial data of companies that have defaulted to understand their credit risk.
credit score that is used to rank firms based on their creditworthiness.
The best known structural credit risk model is the
Merton model
Assumptions of the Merton model
1) default occurs at the maturity date of the debt if the asset value falls below the face value of debt
2) bankruptcy is costless,
3) debt and equity can be traded without friction,
4) debt is a zero-coupon bond with a face value of K and a maturity date of T.
Equity (European call option on the firm’s assets A with strike of K and maturity T) has a value at time T (Et) that may be expressed as
What Does the Merton Model Tell You?
The model allows for easier valuation of a company and helps analysts determine if it will be able to retain solvency, by analyzing the maturity dates of its debt and its debt totals.
Debt (risk-free bond and short put option on the firm’s assets with strike of K and maturity T) has a value at time T (Dt) that represents the payoff to the firm’s bondholders and may be expressed as:
According to Black-Scholes, the value of a European call option may be expressed as:
The probability of default in the Merton model may be expressed as:
Time-t value of risky debt (under merton’s model) can be expressed as?
And it indicates that Put value is?
According to Black-Scholes, value of a European put option may be expressed as
Value of zero coupon bond debt is expressed (in terms of a spread above the risk free rate)
Risk neutral probability of default (q-measure) can be expressed as? (using the merton model)
The KMV model uses two relationships to determine asset value and asset volatility
distance to default (DD) formula
expected default frequency (EDF) formula
probability that a firm has survived for t years may be expressed as:
The probability that default takes place between s and t, assuming no default up to time s, is given by (formula):
What is the price (formula) of a bond that in the event of default has zero recovery:
What is the price (formula) of a bond that in the event of default has some recovery:
