Topic 6: Credit Analysis, single name perspective Flashcards
On balance sheet credit exposures
loans
Off balance sheet credit exposures
- originate loans, then distribute / securitise them
- loan related facilities: stand by facilities, guarantees offered to other lenders or letters of credit to support borrowers.
- Counterparty Credit Risk
2. Credit Valuation Adjustment
- counterparty to a derivatives contract unable to perform
- consider: if your swap is ITM, you have exposure to the counterparty to make that payment.
CVA:
- like an infrequent margin call
CDS
- buyer of swap purchases protection from the seller on a third party (reference credit)
- buyer pays a premium, usually in instalments
- no underlying loans need to change hands
structured credit
structured credit usually involved a portfolio of loans packaged into a series of credit instruments that can be traded
collateralised debt obligation
- portfolio of loans or credit default swaps is structured into tranches
Credit Risk Models are applied in 2 ways
- Assess single name credit risk to quantify 3 key parameters of default (name the three)
- model portfolio effects, especially (name 2)
- a) probability of default (PD)
b) loss given default (%LGD)
c) exposure at default (EAD) - a) correlation
b) diversification
expected dollar loss = ?
expected dollar loss = prob default * % loss given default * % exposure at default
= PD * %LGD * %EAD
If Assets > B
If assets <B
- assets are worth more than the repayment owed to bondholders. Shareholders will repay bondholders in full.
- assets <B: shareholders will walk away from the firm, surrendering it to bondholders. Value of bonds at time T: B(t) = A(t)
Probability of Default
- name 2 types of measures
- Qualitative measures
- expert opinion on balance sheet analysis and knowledge of credit - Quantitative models
- financial ratio style models
- structured models
- reduced form models
Balance Sheet=
Assets:
- Value = A
Liabilities:
- Debt: promised repayment = K
- Value of Debt = D = PV(K)
- Equity: Value = S
balance sheet equation
A = D + S = PV(K) + S
(measured at an instant in time, depends on debt or credit spread & time horizon)
K is a constant, eg face value of a zero coupon bond (K = promised repayment)
Firm is insolvent if:
Firm is insolvent if A(T) < K
(ie assets on date of debt maturity is less than the promised debt repayment). ]
In the case of default, equity is worthless
A(T) is MARKET VALUE
Probability of Default =
PD = Pr{A(T)t default} = 1 - N(d2) = N(-d2)
Probability of default varies xxxxxx with the distance to default
Probability of default varies INVERSELY with the distance to default
ie the higher (lower) the distance to default the lower (higher) the PD
Merton Default Model
- define
- payoff resembles…
- substitute values…
- default prediction tool to predict asset value (A) falling below liability value (K) on the date the debt becomes due and payable
- payoff resembles call option (S = value of call option on A with strike K.
- substitute stock value S for the call option value
- substitute A for the stock price
% expected recovery rate = ?
% expected recovery rate + %LGD = ?
% expected recovery rate = expected recovery amount / K
% expected recovery rate + %LGD = 100%
d2 =
d2 = distance to default
distance to default is measured in units of SD of the asset log value; NOT log dollar terms
distance to default measures:
distance to default measures how far the expected asset log value is from the promised debt repayment log value. That measurement is in units of SD of the asset log value
d2 is therefore a z score. PD = N(-d2)
CDS - define
CDS: provides credit protection on an underlying reference asset
Protection buyer pays premium to protection seller
Seller “makes good” in the case of default - eg take delivery of reference asset or make cash payment
Price of CDS =
CDS Price = difference between price of risk free bond and the risky bond
Credit Linked Note
construct from high quality AAA investment minus CDS
Loss Given Default
severity of loss once default happens
- expressed as % of amt outstanding at default
- %LGD > 100% is possible if nothing is recovered but lender incurs workout costs or legal costs trying to recover something
%LGD observations
- %LGD is greater the further down the capital structure it is
- secured debt likely to have lower L\GD than unsecured
- LGD varies with business cycle
Exposure At Default (EAD)
- actual exposure a counterparty has to another at the time of default
- expressed as simple dollar number, proportion of commitment size or as proportion of unutilised portion of commitment.
3 areas to analyse for EAD
`- undrawn loan commitments
- contingent exposures (eg guarantees, letters of credit)
- derivatives exposure (market related)
Managing counterparty risk
- netting / set off agreements
- collateral
- limits
- credit valuation adjustment
- capital (last layer of resort against loss - capital must be enough)
- central counterparties
- CDS
credit valuation adjustment (CVA)
- difference between risk free value of the transaction and the traded price is the CVA
- if the value at which you discount goes higher; the value of the deal is lower. you want this value from them in cash to offset the value of loss on the reval with credit rating downgrade etc.
** Importance of growth of assets **
Growth of assets (growth in asset log value) determines firm’s ability to pay back debt
** Expected dollar loss = **
Expected dollar loss = PD * % LGD * % EAD
* Distance to Default*
Distance to default = how far a borrower is from defaulting on obligations
- difficulty is how to measure
** Altman’s Z **
Altman’s Z:
1. early attempt to determine distance to default
2. Altman’s Z goes up as distance to default goes up
the borrower with higher Z is safer
- ** PD Probability of Default / Merton ***
1. links with
2. key elements (5)
Merton & PD
- Option based perspective links well with the value relationship between Debt & Equity on the liability side of the Balance Sheet
- Focuses on key elements:
- asset value now
- amount the firm has borrowed
- expected return on assets
- volatility of assets
- time horizon
* Time*
“Time is a convenient proxy variable. It is highly correlated with many causal factors. The problem is that the correlation can flip from positive to negative.
Once a credit spread is calculated; explain large magnitude of difference between assumed PD and market pricing of PD
(4)
- S&P estimates of PD are a long term, through the cycle estimate. During economic hardship expect PD to be higher
- %LGD could also be higher due to economic hardship. Increase %LGD would mean estimate of PD would come down
- One is a risk neutral measure of default while the other is not.
- Market liquidity; risk averse investors sell risky Greek bonds buy German bonds. In flight to quality market liquidity can be poor.
How do you estimate the value of a CDS
CDS is replicated by investing in a risk free bond and selling a risky bond.
More often, CDS is quoted in terms of spread that should be approx. the same as that in the debt markets
If log asset return has negative skew and heavy tails, what is the impact on prob of extreme move down vs that of a normal distribution
- Extreme move down for negatively skewed distribution will be greater than predicted under a normal distribution
- True probability of default will be greater than if under a normal situation
Credit Risk:
Ways to decrease credit exposure (consider a sold call with partic strike)
- Increase the strike of the option
- Reduce the term of the transaction
- Add a long OTM call
- Assume lower volatility (note this tweaking not appropriate for the purposes of getting trade within limits)
% loss given default (%LGD) primarily depends on these factors (2)
- type of security
- seniority of claim
- Is the transaction collateralised
- %LGD tends to be highest when probability of default is high.
PD * indicates (?)
PD * indicated risk neutral default probability. In a risk neutral world, for valuation purposes only one rate of return is used, the rf rate
Explain call elasticity
- Delta measures the sensitivity of the option value to changes in S; measured in dollars
- Elasticity measures this sensitivity in percentage terms
Difference between calculated vol of option vs actual
Due to :
- sampling error
- delta and elasticity are changing each day with the stock price
Merton model: substitutions
- The stock is a call option on the firm
- Asset value substitutes for S
- Value of equity substitutes for c
elasticity (s) = A*delta / S - If stock has no dividends, delta = N(d1)
- Volatility of STOCK is greater than volality of ASSETS because MV assets generally > MV of non equity liabilities; and elasticity (stock) therefore > 1. (ie >100%)
*** d2 (hat) = ?
d2 (no hat) = ?
d2 = Z score along horizontal axis. Can be used as distance to default
d2 (hat) = used if miu (ie growth rate of assets) is based on alpha; this is the REAL distance to default
d2 (no hat) = used if is based on r, ie the RISK NEUTRAL distance to default
Each has an associated PD and in general they are different
How much bondholders get back after a firm has defaulted depends on: (5)
- position of debt instrument in firm’s capital structure
- degree to which the instruments are backed by liquid assets
- cyclical trends (eg macroeconomic factors & credit cycle)
- relative strength of firm in its industry
- nature & severity of default event
LGD vs recovery
LGD = 1 - recovery rate
Increase probability of default:
- increase firm liabilities (K)
- increase volatility (sigma)
- decrease assets (A)
- decrease expected rate of return for assets (miu) Miu is ex cashflows that might be generated, ie alpha - div yld
- Time - this impact varies (can increase or decrease default.
2 effects for time on default probability
- increase T, tails get larger
2. asset values can increase with time
