Reading 45 - Credit Analysis Models Flashcards
Generally define what Credit Risk is……
The risk associated with losses stemming from the failure of a borrower to make timely and full payments of interest or principal.
What are the 5 basic credit risk measures for fixed income securities?
- Probability of Default - is the probability that a borrower fails to pay interest or repay principal when due
- Loss given default - refers to the value a bond investor will lose if the insurer defaults. Can be stated as a $ figure or as a % of a bond’s value
- Recovery rate - is the percentage of money received upon default of the issuer …Loss given default(%) = 100 - recovery rate
- Expected loss - is equal to the probability of default multiplied by the loss given default.
- Present Value of Expected Loss - is the highest price a hypothetical investor would be willing to pay to an insurer to bear credit risk of the investment
The Present Value of Expected Loss has these two modifications to the expected loss calculation…..
- Time Value Adjustment - Future expected losses are discounted to their present value
- Risk-neutral probabilities - Adjustment to the probabilities of default is a more complete adjustment that accounts for the risk of the cash flows
Credit scoring models provide ordinal rankings of credit quality. What does this imply?
Ordinal rankings categorize borrowers from highest to lowest but do not communicate the degree to which the credit risk differs amoung different ranks.
What are some characteristics of credit scoring models?
- Credit scores are ordinal rankings
- Credit scores are not percentile rankings, and the distribution of credit scores change over time
- Credit scores do not explicitly take into account current economic conditions, credit scores do not improve with the economy
- Credit scoring agencies are under pressure from users of credit scores to prioritize stability in scores over time
- Credit scoring does not taken into account differing probabilities of default for different loans taken out by the same borrower
What is the issuer-pays model in regards to credit rating?
The borrower pays for being rated by the credit rating agencies…
**This creates a conflict of interest in that the rating agency could feel pressure to issue the payer a favorable rating.
What are 2 strengths of Credit Ratings?
- Are simple to understand and summarize complex credit analysis in one metric
- Tend to be relatively stable over time, reducing volatility in the debt markets
What are 3 weaknesses of Credit Ratings?
- The stability in credit ratings comes at the expense of a reduction in correlation with default probability
- Ratings do not adjust with the business cycle, even though the probability of default changes with the business cycle.
- In the case of the issuer-pays model, the conflicts of interest may make the ratings less reliable.
Explain structural models of corporate credit risk….
***Critical Concept**
They are based on the structure of a company’s balance sheet and rely on insights provided by option pricing theory.
What is the key assumption of the structural model that makes it impractical in use?
That the assets of the company are traded in the market.
How is a reduced form model different than a structural model?
Reduced form does not impose assumptions on the company’s balance sheet, instead they impose assumptions on the output of a structural model. This also allows the analyst flexibility to incorporate real world conditions in the model
What is hazard rate estimate in regards to reduced form models?
a technique for estimating the probability of a binary event (two possible outcomes) such as default or no default and can be done using a logistic regression
What are 3 assumptions of a structural model?
- The company’s assets are traded in frictionless arbitrage-free market with a time T value that has a lognormal distribution with mean uT and variance of o2 T
- The risk free rate (r) is constant over time. This implies that there is no interest rate risk, which is illogical in fixed-income valuation
- The company has a simple balance sheet structure with only one class of simple zero-coupon bonds
What are 2 strengths of structural models?
- Allows us to use option pricing theory to understand a company’s probability of default and loss given default
- The structural model can be estimated using current market prices
What are 3 weaknesses of structural models?
- The balance sheet cannot be modeled realistically using a single zero-coupon bond, meaning that recovery rates and default probabilities may be inaccurate
- Company assets are not actually traded, and hence, their value is not directly observable.
- Estimation procedures do not consider the business cycle.
Given the information, how would you calculate the present value of the expected loss for the payment in 0.5 yrs?
- A 6% semiannual coupon bond
- Maturing in 3 years
PV of expected loss at 0.5 years is PV (risk free) - PV (risky)
= 29.98 - 29.96
Given the information, how would you calculate the present value of expected loss for the bond?
A 6% semiannual coupon bond
Maturing in 3 years
After calculcated the PV of both the risk free and risky, sum them up then subtract risky from risk free
What are the speculative ratings for Moody’s and S&P?
