VRM 4 Flashcards
What is the primary function of credit rating agencies?
To provide independent opinions on credit risk based on specified criteria.
Name three well-known credit rating agencies.
- Moody’s
- Standard and Poor’s (S&P)
- Fitch
What is the highest bond rating assigned by Moody’s?
Aaa
What does a bond rating of D signify?
The firm is already in default.
What are the two categories of default probability?
- Unconditional default probability
- Conditional default probability
Fill in the blank: Instruments with ratings of BBB- or above are considered _______.
investment grade
What is the hazard rate?
The rate at which defaults are happening at time t.
How is the unconditional default probability calculated using the hazard rate?
1 — e^(-h̄t)
What is the expected loss from a loan formula?
EL = PD × LGD
What does LGD stand for and how is it calculated?
Loss Given Default; LGD = 1 - RR
Define recovery rate.
The value of the bond shortly after default expressed as a percentage of its face value.
What significant regulatory change followed the 2007-2008 financial crisis regarding rating agencies?
The Dodd-Frank Act requires transparency in the assumptions and methodologies underlying ratings.
What is the role of the Office of Credit Ratings?
To provide oversight of rating agencies.
True or False: Ratings for money-market instruments are termed long-term ratings.
False
What is the average recovery rate for junior bonds according to Moody’s?
Around 25%
What are the three prime rating categories used by Moody’s for money market instruments?
- P-1
- P-2
- P-3
What is the link between default rates and recovery rates during economic cycles?
Recovery rates are negatively correlated with default rates.
What is a ratings transition matrix?
A tool used to describe and interpret changes in credit ratings over time.
Fill in the blank: The probability of defaulting during a given year is called _______.
conditional default probability
List two consequences of the role of rating agencies in the credit crisis.
- Increased legal liability of rating agencies
- Creation of the Office of Credit Ratings
What is the relationship between the cumulative default probability and the hazard rate?
The average hazard rate can be derived from the cumulative default probability.
How does the probability of default behave for investment grade bonds over time?
It is an increasing function of time for the first four years.
What does the term ‘non-prime’ indicate in the context of money market ratings?
It signifies a non-investment grade rating.
What is the average recovery rate for junior bonds?
Around 25%
Junior bonds are subordinate to other bonds, resulting in lower recovery rates during defaults.
What is the average recovery rate for senior secured bonds?
Around 50%
Senior secured bonds have higher priority in claims during defaults.
What is the correlation between recovery rates and default rates during recessionary periods?
Negatively correlated
High default rates during recessions coincide with low recovery rates.
What is a credit spread?
The extra interest earned on an asset over the risk-free rate for assuming risk
Credit spreads for bonds tend to be relatively high.
Why do bond holders require a risk premium?
Bonds do not default independently of each other
Systematic risk arises when default rates fluctuate significantly.
What are the four types of outlooks in the rating process?
- Positive outlook
- Negative outlook
- Stable outlook
- Developing outlook
These outlooks indicate the likely direction of a rating change.
What does it mean if a rating is placed on a watchlist?
A relatively short-term change is anticipated
Watchlists can indicate either a potential upgrade or downgrade.
What is the importance of rating stability for rating agencies?
It reduces transaction costs for bond traders and maintains the reliability of financial contracts
Frequent rating changes could complicate collateral management.
What is a through-the-cycle rating?
Captures the average creditworthiness of a firm over several years
It is less affected by economic fluctuations.
What is a point-in-time rating?
Provides the best current estimate of future default probabilities
It can overstate or understate default probabilities based on economic conditions.
What does the NR column in rating transition matrices indicate?
The probability that a firm is no longer rated at the end of a year
This is important for analyzing rating transitions.
What is the purpose of internal ratings for banks?
To assess potential borrowers and comply with regulatory requirements
Internal ratings help in determining regulatory credit risk capital.
What statistical technique did Altman use to develop the Z-score?
Discriminant analysis
The Z-score uses ratios to predict default probability.
What does a high credit spread indicate?
Increased risk associated with the bond
High liquidity risk may also contribute to higher credit spreads.
What is the relationship between rating changes and economic cycles?
Downgrades increase during recessions despite ratings being designed to be through-the-cycle
Ratings may not always reflect immediate economic conditions.
What is one limitation of using external ratings?
External ratings may not always be available
This can lead banks to develop their own internal rating systems.
How do KMV and Kamakura estimate default probabilities?
Using models that include factors like debt amount, market value of equity, and volatility
These models provide point-in-time estimates.
What is a key difference between rating structured products and traditional ratings?
Structured product ratings depend almost entirely on a model
This was evident during the 2007-08 financial crisis.
What is the reason why downgrades impact prices while upgrades do not?
Downgrades affect the willingness of investors to hold bonds and may have negative implications due to contracts involving rating triggers.
How does the rating of structured products differ from traditional rating practices?
The rating of structured products depends almost entirely on a model.
During the 2007-08 crisis, how did S&P and Fitch base their ratings for structured products?
They based their ratings on the probability that the structured product would give a loss.
How did Moody’s base its ratings for structured products during the 2007-08 crisis?
Moody’s based its ratings on expected loss as a percent of the principal.
What was a significant flaw in the models used by rating agencies during the financial crisis?
The inputs, particularly the correlations between the defaults on different mortgages, proved to be too optimistic.
What happened when the creators of structured products understood the models used by rating agencies?
They designed structured products in a way that achieved the ratings they desired.
What did rating agencies find profitable during the crisis?
The work on structured products.
Why did the reputation of rating agencies suffer during the 2007-2008 crisis?
Many structured products created from mortgages defaulted.
What change occurred regarding oversight of rating agencies after the crisis?
Rating agencies are now subject to more oversight than before.
Fill in the blank: Rating of structured products depends almost entirely on a _______.
[model]
True or False: Upgrades to investment-grade ratings have a significant impact on bond prices.
False
