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:
Merton’s model describes risky debt as a ____with a long position in ____(with same maturity as the risky debt) and a short position in a ____ with the same maturity date as the debt and a strike price equal to the debt’s ___
portfolio
risk free debt
put option
face value K
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)
Merton model has two key outputs:
probability of default & credit spread
Risk neutral probability of default (q-measure) can be expressed as? (using the merton model)
Advantage of the Merton Model
it has several intuitive properties and serves as a basis for more complex models
2 major shortcomings of the merton model
- Some of the model’s parameters are not easily observable (i.e., market value of the firm’s assets and their volatility).
- Not successful at explaining the credit spread on short-term securities
Merton model has four important properties related to the sensitivity of its two key outputs (i.e., probability of default and credit spread) to changes in four of its inputs
1) sensitivity to maturity
2) sensitivity to asset volatility
3) sensitivity to leverage
4) sensitivity to riskless rate
Non-cumulative probability of default refers to the
likelihood that a borrower will default on a financial obligation within a specific period
credit spread, also known as a ____, is the ___
yield spread
difference in yield between two debt securities of the same maturity but different credit quality
describe what is the relationship of credit spread and its Sensitivity to maturity in a merton model
at short maturities the credit spread is low, its stars to grow as the maturities become longer, however, tamper off after some point
highly leveraged firms can quickly have high ____term default probabilities. However, at longer maturities, credit spreads can decline because:
short
for highly-levered firms that survive for several years without default, their
assets’ positive expected returns will cause long-term default probabilities to decline
describe what is the relationship of probability of default and therefore credit spread and its Sensitivity to asset volatility in a merton model
As asset volatility increases, the probability of default increases (at a decreasing rate) and the credit spread increases
Why at very high volatility levels, the increase in credit spread will start to decrease for long-term bonds?
Since asset values cant be negative, (i.e., negative effect of higher volatility is limited to the downside and positive effect is unlimited on the upside).
describe what is the relationship of probability of default and credit spread and its Sensitivity to leverage in a merton model
As leverage increases, both the default probability and credit spread increase.
As leverage increases, the default probability increases by ____for long-term bonds and the credit spread may increase by a ____amount for long-term bonds for what reason?
more
smaller
Because the asset prices have a limited downside and therefore the credit spread will start to decrease
describe what is the relationship of probability of default and credit spread and its Sensitivity to riskless rate in a merton model
as the riskless rate increases, the assets’ average return increases, which reduces the default probability and the credit spread
What does KMV stand for in the KMV model?
Kealhover, McQuown, and Vasicek (KMV)
What type of credit model is the KMV model and how does it assess the credit risk?
structural credit risk model
estimates the credit risk of debt by considering the loan repayment incentive problem from the perspective of the borrowing firm’s equity holders.
How does the KMV model aim to overcome a shortcoming of the Merton model?
By estimating the VALUE of assets and their VOLATILITY of assets simultaneously using the Merton model and the economic relationship between equity values and firm values
The KMV model uses two relationships to determine asset value and asset volatility
two key outputs of the KMV model are the
1) probability of default (referred to as expected default frequency by KMV)
2) credit score (referred to as a borrower’s distance to default).
What is the other name for DISTANCE TO DEFAULT
credit score
What is the other name for expected default frequency
probability of default
What is the difference in how Merton and KMV model default
1) Merton’s default trigger is when the asset value becomes less than the value of the debt
2) KMV’s default trigger is when the asset value becomes less than the entire short-term debt and part of the longer-term debt
What is a default trigger?
An occurance that triggers the default on debt
The distance to default (DD) is the _____ away from default
number of standard deviations
distance to default (DD) formula
expected default frequency (EDF) formula
The EDF can be used to estimate the ____ of bonds issued by these firms
credit spread
What does it mean that Reduced-form models take default as being exogenous?
they do not consider the causes of default.
Key drivers in these models include time to default and recovery in the event of default (or loss given default)
probability that a firm has survived for t years may be expressed as:
The probability of default at or before t is given by (formula)
1- p(t).
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:
two key reduced-form credit models.
1) Jarrow-Turnbull (1995) model - assumes that, regardless of the timing of default, recovery is received at the maturity date
2) Duffie-Singleton (2003) - model allows the recovery process to occur at any time and sets the recovery amount to a fraction of the non-defaulting bond price at the time of default.
Empirical credit models (sometimes referred to as _____) differ from structural and reduced-form models in 2 key ways:
credit scoring models
- They use historical default data to gain a rudimentary understanding of credit risk (since they assume that the default process is too complex to be modeled).
- They do not estimate the probability of default or credit spread.
Altman’s Z-score model is an econometric credit scoring model based on ___ financial ratios that generates a Z-score (or ____)
five
credit score
Altman developed a rule for interpreting the absolute values of Z-scores.
1) Default group:
2) Gray zone:
3) Non-default group:
1) Z < 1.81
2) 1.81 < Z < 2.99
3) Z > 2.99
5 FINANCIAL RATIOS USED TO DETERMINE ALTMAN’S Z-SCORES
- X1: Working capital/Total assets (working capital = current assets - current liabilities)
- X2: Retained earnings/Total assets
- X3: Earnings before interest and taxes/Total assets
- X4: Market value of equity /Book value of total liabilities
- X5: Sales/Total assets (asset turnover ratio)
