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Question: What is an appropriate modeling approach to value defaultable debt (bonds and loans)?
Gieseke
Credit Risk Modeling and Valuation: An Introduction, October 2004
1. We want to use the structural approach to incorporate bond default risk in bond valuation
The value of the firms assets are assumed to follow the process,
where is the instantaneous expected rate of return on assets, and is the standard deviation of the return on assets. Let D(t,T) be the date t market value of debt with promised payment B at date t.
The second line in (18.2) says that the payoff to the creditors equals the promised payment (B) minus the payoff on a European put option written on the firms assets with exercise price B.
Shareholder equity is similar to a call option on the firms assets, since at maturity the payoff to equity holders is max [A(t) B, 0]. However, shareholder equity is different from a European option if the firm pay dividends to shareholders prior to maturity as reflected in the first term of the last line in (18.4) where denotes the dividend rate.
First passage model - - bond indenture provisions often include safety covenants that give bond holders the right to reorganize the firm if the value falls below a given barrier.
The first passage model defines the survival probability as p(t,T) that the distance to default does not reach zero at any date between t and T. The distance to default is often measured in terms of standard deviations.
Structural approach: default in the first passage model (Black & Cox, 1976)
2. We want to use the reduced form approach to incorporate bond default risk in bond valuation
The reduced form model was developed to overcome the nontradeability and nonobservability of the firms asset value process (Jarrow &Turnbull, 1992). Default is not tied to the dynamics of asset prices and this breaks the link between the firms balance sheet and the likelihood of default. Rather, default is based on an exogenous Poisson process, so it may be better able to capture the effects of default due to additional unobserved factors. Reduced form models can also be used to value defaultable bonds using the techniques used for default-free bonds. In the reduced form framework, we assume that the default event depends on a reduced form process, that may depend on the firms assets and capital structure, but also on other macroeconomic factors that influence default.
The default event for a firms bond is modeled as a Poisson process with a time-varying default intensity. Conditional on no default occurring up to date t, the instantaneous probability of default at (t, t+dt) is denoted as (t) dt, where (t) is the physical default intensity, or hazard rate, where it is assumed that (t) 0. Since (t) is time-varying, it may be linked to changes in underlying state variables. We can compute the physical probability that a bond will not default from date t to date where t T. This physical survival probability is written
where r is the instantaneous default-free interest rate, which gives us the risk-neutral default intensity rather than the physical default intensity in (18.5). The risk-neutral default intensity accounts for the market price of risk due to the Poisson arrival of the default event.
So, (18.9) indicates that valuing a zero-recovery defaultable bond is similar to valuing a default-free bond, except that we use the discount rate, r(u) + (t), rather than just r(u).
Pennacchi - Problem #2
Pennacchi - Problem #3
Default depends on both Brownian motion vector (dz) for the state variables and the Poisson process (dq) for arrival of default) - - the default process is doubly stochastic
3. We want to extend the structural and reduced form models for bonds to the case of bank loans
The link between loans and optionality can be illustrated by a payoff function to a bank lender. Here repayment of the loan requires amount 0B. But the market value of project assets can be AL or AH. At AL the borrow would have an incentive to default on the loan contract by forfeiting the assets to the bank. Above 0B the bank earns a fixed return on the loan. This is analogous to the payoff to a put option writer on a stock with exercise price B.
Based on a sufficiently large sample of firms, we can map the distance to default into EDF
The loss distribution for a single loan portfolio (severity rate = $20,000 per $100,000 of loan)