myra training 3

Introduction to Credit Risk

Credit Course and Rating Agencies

Emre Tezmen

MYRA Training

18 Şubat 2010

Emre Tezmen Credit Course and Rating Agencies


Goals of The TrainingClassification of Financial RisksMeasuring Credit RiskBonds and Default Modelling Challenge

What do We Aim With This Presantation?

Provide an understanding of the basic principles of credit risk






Learn how to model default events, default probabilities, andbond prices







Learn how to calibrate and apply these models in practice








Provide an understanding of the structure and rationale ofpopulare derivate products for credit risk insurance








Provide an understanding of the structure and rationale ofpopulare derivate products for credit risk insurance

Learn how to analyze the risk and value of these transactions




Financial Risks

In classical parlance, we can outline financial risks as:

Market risk: possibility of unexpected changes in market pricesand rates




Financial Risks



Operational risk: possibility of mistake or breakdown intrading/risk management operation




Financial Risks




- Mis-pricing of instruments




Financial Risks




- Mis-pricing of instruments- Mis-understanding of involved risks




Financial Risks




- Mis-pricing of instruments- Mis-understanding of involved risks- Fraud (’rough trader‘)




Financial Risks




- Mis-pricing of instruments- Mis-understanding of involved risks- Fraud (’rough trader‘)- Systems failure




Financial Risks




- Mis-pricing of instruments- Mis-understanding of involved risks- Fraud (’rough trader‘)- Systems failure- Legal exposure due to inappropriate services




Financial Risks II

Or we can define financial risk in a more eloborate way:

Liquidity risk: possibility of increased costs/inability to adjustposition(s)




Financial Risks II



- Bid-ask spreads widen dramatically over a short period of time




Financial Risks II



- Bid-ask spreads widen dramatically over a short period of time- Access to credit deteriorates




Financial Risks II




Credit risk: possibility of losses due to unexpected changes inthe credit quality of a counterparty or issuer




Financial Risks II




Credit risk: possibility of losses due to unexpected changes inthe credit quality of a counterparty or issuer

Systemic risk: market-wide liquidity breakdowns ordomino-style correlated defaults




Market vs.Credit Risk

Basically, credit risk is part of market risk. But there are illiquidcontracts for which market prices are not available, for exampleloans. Other differences may be stated as:

Market Risk Credit Risk

Time horizon short (days) long (years)Portfolio static dynamicHedging standardized often customizedInformation market related contract specificData abound sparse




Some Sources of Credit Risk

Exposure to the credit risk of an underlying, for example






- Bank loan






- Bank loan- Corporate or sovereign bond







Exposure to the credit risk of the (OTC) counterparty:vulnerable claims







Exposure to the credit risk of the (OTC) counterparty:vulnerable claims

Combinations of both, for example with options on corporatebonds




Components of Credit Risk

Default

- Not receiving ALL you were promised- Probability of Default

Recovery

- How much do you receive?- Fraction of the owed amount recoverd by the lender- Usually expressed as a % of owed notional- Loss Given Default= 1 - Recovery Rate




Why Measure & Manage Credit Risk

♣ Perfect vs. Imperfect Markets





♣ Perfect vs. Imperfect MarketsIn perfect capital markets, adding/subtracting financial risk hasno impact on the market value of a firm (Modigliani-Miller)





♣ Perfect vs. Imperfect MarketsIn perfect capital markets, adding/subtracting financial risk hasno impact on the market value of a firm (Modigliani-Miller)In imperfect capital markets, measuring and managingfinancial risk has significant benefits





♣ Perfect vs. Imperfect MarketsIn perfect capital markets, adding/subtracting financial risk hasno impact on the market value of a firm (Modigliani-Miller)In imperfect capital markets, measuring and managingfinancial risk has significant benefitsDue to informational asymmetries, credit markets are imperfect






♣ Bank’s response to credit market imperfections?






♣ Bank’s response to credit market imperfections?Increase average interest rates (take a ’lemon’s premium’ )







- Adverse selection: Bad risks remain at the bank








- Moral hazard: Incentive for borrower to gamble, particularly

for large loan sizes










Reduce exposure, but this may lead to credit rationing andreduces potential profits










Reduce exposure, but this may lead to credit rationing andreduces potential profits

♣ In practice, banks would set both interest rates and exposurelimits according to the measured credit risk of the borrower.




Credit Ratings

♣ Credit Event may be said to lead a change the credit quality ofan issuer and classified as:




Credit Ratings


Restructuring




Credit Ratings


RestructuringFailure to pay




Credit Ratings


RestructuringFailure to payRepudiation




Credit Ratings


RestructuringFailure to payRepudiationBankruptcy




Credit Ratings


RestructuringFailure to payRepudiationBankruptcyIn case of the last three events we also speak of a ’default’.




Credit Ratings



♣ Credit Ratings provide information about corporate defaultprobabilities i.e. credit worthiness of bonds. Ratings are issuedby private rating agencies:




Credit Ratings




S&P: classes AAA, AA; A, BBB, BB, B, CCC; with AAA thebest




Credit Ratings




S&P: classes AAA, AA; A, BBB, BB, B, CCC; with AAA thebestMoody’s: classes Aaa, Aa, A, Baa, Ba, B, Caa, with Aaa thebest




Credit Ratings




S&P: classes AAA, AA; A, BBB, BB, B, CCC; with AAA thebestMoody’s: classes Aaa, Aa, A, Baa, Ba, B, Caa, with Aaa thebestBonds with ratings of BBB/Baa and above are considered’investment grade‘; below are considered non-investment grade




Moody’s Average Cumulative Default Probabilities

1970-2003

Years 1 2 3 4 5 7 10 15 20

Aaa 0,00 0,00 0,00 0,04 0,12 0,29 0,62 1,21 1,55Aa 0,02 0,03 0,06 0,15 0,24 0,43 0,68 1,51 2,70A 0,02 0,09 0,23 0,38 0,54 0,91 1,59 2,94 5,24

Baa 0,20 0,57 1,03 1,62 2,16 3,24 5,10 9,12 12,59Ba 1,26 3,48 6,00 8,59 11,17 15,44 21,01 30,88 38,56B 6,21 13,76 20,65 26,66 31,99 40,79 50,02 59,21 60,73

Caa 23,65 37,20 48,02 55,56 60,83 69,36 77,91 80,23 80,23




S&P’s Average Cumulative Default Probabilities 2001

Years 1 2 3 4 5 10

AAA 0,00 0,00 0,07 0,15 0,24 1,40AA 0,00 0,02 0,12 0,25 0,43 1,29A 0,06 0,16 0,27 0,44 0,67 2,17

BBB 0,18 0,44 0,72 1,27 1,78 4,34BB 1,06 3,48 6,12 8,68 10,97 17,73B 5,20 11,00 15,95 19,40 21,88 29,02

CCC 19,79 26,92 31,63 35,97 40,15 45,10




Defaultable and Default Free Bonds

Two types of bonds: default free and defaultable






BT

t price at time t of a default free zero-coupon bond paying 1at T






BT


Bond yield y(t,T ) satisifes BT

t = e−y(t,T )(T−t)






BT



t = e−y(t,T )(T−t)

BTt price at time t of a defaultable zero-coupon bond paying 1

at T






BT



t = e−y(t,T )(T−t)


at T

Bond yield y(t,T ) satisfies BTt = e−y(t,T )(T−t)






BT



t = e−y(t,T )(T−t)


at T


Credit yield spread S(t,T ) is then

S(t,T ) = y(t,T )− y(t,T ) = −1

T − tln

BTt

BT

t






BT



t = e−y(t,T )(T−t)


at T


Credit yield spread S(t,T ) is then

S(t,T ) = y(t,T )− y(t,T ) = −1

T − tln

BTt

BT

t

The term structure of credit spreads is the schedule of S(t,T )against T




Defaultable and Default Free Bonds A Numerical Example I

Being said the relation between a risky and risk free asset thequestion remains: How do we translate bond calculations into onesimple default probability expressed in %?

Years Default Recovery Default Free Default Discount PVProbability Rate VB Loss Rate Loss

1 λ 30 104,5 74,5 0,95 70,9 λ

2 λ 30 104,6 74,6 0,90 67,5 λ

3 λ 30 104,7 74,7 0,86 64,3 λ

4 λ 30 104,8 74,8 0,82 61,2 λ

5 λ 30 104,9 74,9 0,78 58,3 λ

6 λ 30 105 75 0,74 55,6 λ

Total 377,8λ




Defaultable and Default Free Bonds A Numerical Example II

Solving for λ, Default Probability

λ =14, 6

377, 8≈ 0, 039 = 3, 9%

Where does this magical number 14,6 come from?




Present Value of Expected Loss I

A risky bond maturing in six years pays an annual coupon of%5, and yield to maturity is %8

A risk-free bond, maturing at te same time pays an annualcoupon of %5, and yield to maturity is %5

Risky Bond Price (X )

PVX = 5e−0,08∗1 + 5e−0,08∗2 + · · ·+ 105e−0,08∗6 = 84, 76

Risk Free Bond Price (B)

PVB = 5e−0,05∗1 + 5e−0,05∗2 + · · ·+ 105e−0,05∗6 = 99, 36




Present Value of Expected Loss II

And here comes the magic:

14, 6 = PVB − PVX = 99, 36 − 84, 76




Defaultable Bonds Issuer and Credit Risk

A firm has a given probability of defaulting and not paying allit borrowed.






So where does credit risk show up?







Credit risk will determine the borrowing costs of that company:








- The firm will have to pay higher coupon on its bonds in orderfor investors to be willing to buy them








- The firm will have to pay higher coupon on its bonds in orderfor investors to be willing to buy them

- Banks will require higher interests on the loan




Default Modelling Challenges

How can we model the default event, default probabilities, andbond prices?

1 Structural approach: Economic arguments about why a firmdefaults







1 Classic option-theoretic model of Merton (1974)







1 Classic option-theoretic model of Merton (1974)2 First-passage model








2 Reduced form/intensity based approach: Tractable ad-hocfinancial engineering type approach








2 Reduced form/intensity based approach: Tractable ad-hocfinancial engineering type approach

3 Hyprid approach: Unifies economic and financial engineeringtype arguments


myra training 3

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