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Fin431x (Ch 20&21) 1
Credit Rating and Credit Risk Modeling
1. Major components of corporate bond credit analysis
2. Business risk
3. Corporate Governance Risk
4. Financial Risks
5. Alternative credit risk models
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Fin431x (Ch 20&21) 2
Overview of Credit AnalysisAnalysis of Covenant
Analysis of Collateral
Analysis of Issuer’s Ability to Pay
•Business risk
•Corporate governance risk
•Financial risk
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Fin431x (Ch 20&21) 3
Analysis of Business Risk
• Business risk is the risk associated with operating cash flows, such as industry trends, operating environment, profitability, competition
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Fin431x (Ch 20&21) 4
Corporate Governance Risk
Ownership structure of the corporation
See four key elements evaluated by S&P on page 452.
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Fin431x (Ch 20&21) 5
Financial Risk
• Interest rate coverage ratio: measuring the number of times interest charges are covered on a pretax basis. One is defined as EBITDA/interest expenses. See page 454.
• Leverage ratio – example is the ratio of total debt to EBITDA for a trailing 12-month period
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Fin431x (Ch 20&21) 6
Financial RiskCash flow: see alternative cash flow measures on
page 455: company with a high percentage of assets in cash and marketable securities is in a much stronger position than a company whose primary assets are illiquid real estate.
Net assets: may refer to liquidation value of a firmWorking capital: the stronger the companies
liquidity measure, the better it can weather a downturn in business and reduction in cash flow. – should look at different items as well.
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Fin431x (Ch 20&21) 7
Case
Lear Corp. (LEA)
A high-yield bond
http://www.lear.com/index.jsp
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Fin431x (Ch 20&21) 8
Credit Risk Modeling
Credit risk models are used to measure, monitor, and control a portfolio’s credit risk.
Difficulties:
1. Credit default is a rare event
2. Types of borrowers vary widely
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Fin431x (Ch 20&21) 9
Structural Models
Originated from option pricing models where common stockholders can be viewed as having a call option on the value of the assets with the right being granted by the bondholders
BSM – page 497.
The option is triggered when the firm defaults
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Fin431x (Ch 20&21) 10
Reduced-form Models
Treating default as an exogenous event
Model it with a Poisson process
Jarrow-turnbull Model
Duffie-Singleton Model
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Fin431x (Ch 20&21) 11
Exercises
1. Question 4, chapter 20