Beruflich Dokumente
Kultur Dokumente
By: A V Vedpuriswar
October 4, 2009
If the counterparty defaults, while the contract has negative value, the solvent party typically cannot walk away from the contract.
But if the defaulting party goes bankrupt, while the contract has a positive value, only a fraction of the funds owed will be received.
Data
There are serious data limitations. Market data is plentiful.
Liquidity
Market prices are readily available for instruments that give rise to market risk.
However, most credit instruments don't have easily observed market prices.
There is less liquidity in the price quotes for credit instruments, such as bank loans, compared to interest rate instruments or equities. This lack of liquidity makes it very difficult to price credit risk for a particular obligor in a mark-to-market approach. To overcome this lack of liquidity, credit risk models must sometimes use alternative types of data (historical loss data).
Distribution of losses
Market risk is often modeled by assuming that returns follow a normal distribution though sometimes it does not hold good. The normal distribution, however, is completely inappropriate for estimating credit risk. Returns in the global credit markets are heavily skewed to the downside and are therefore distinctly non-normal.
Expected Loss
The expected loss (EL) is the amount that an institution expects to lose on a credit exposure over a given time horizon.
EL = PD x LGD x EAD
If we ignore correlation between the LGD variable, the EAD variable and the default event, the expected loss for a portfolio is the sum of the individual expected losses. How should we deal with expected losses?
In the normal course of business, a financial institution should set aside an amount equal to the expected loss as a provision. Expected loss can be built into the pricing of loan products.
8
Unexpected loss
Unexpected loss is the amount by which potential credit losses might exceed the expected loss. Traditionally, unexpected loss is the standard deviation of the portfolio credit losses. But this is not a good risk measure for fat-tail distributions, which are typical for credit risk. To minimize the effect of unexpected losses, institutions are required to set aside a minimum amount of regulatory capital.
Apart from holding regulatory capital, however, many sophisticated banks also estimate the necessary economic capital to sustain these unexpected losses.
Stress Losses
Stress losses are those that occur in the tail region of the portfolio loss distribution. They occur as a result of exceptional or low probability events (a 0.1% or 1 in 1,000 probability in the distribution below). While these events may be exceptional, they are also plausible and their impact is severe.
10
11
12
13
14
In the discounted contractual cash flow approach, the current value of a non-defaulted loan is measured as the present value of its future cash flows. The cash flows are discounted using credit spreads which are equal to market-determined spreads for obligations of the same grade. If external market rates cannot be applied, spreads implied by internal default history can be used. The future value of a non-defaulted loan is dependent on the risk rating at the end of the time horizon and the credit spreads for that rating. Therefore, changes in the value of the loan are the result of credit migration or changes in market credit spreads. In the event of a default, the future value is determined by the recovery rate, as in the default mode paradigm.
15
16
17
Structural Models
Probability of default is determined by the difference between the current value of the firm's assets and liabilities, and also by the volatility of the assets.
Structural models are based on variables that can be observed over time in the market.
18
20
Credit Metrics
Credit Risk+
23
24
25
On the other hand, - max {D-VT, 0} is the pay off from a short position in a put option on the firms assets with a strike price of D and a maturity date of T
Thus risky debt long default risk free bond + short put option with strike price D
26
27
Value of equity
Let E be the value of the firms equity. Let E be the volatility of the firms equity. Claim of equity = VT D if VT D = 0 otherwise
The pay off is the same as that of a long call with strike price D.
28
29
Problem
The current value of the firm is $60 million and the value of the zero coupon bond to be redeemed in 3 years is $50 million. The annual interest rate is 5% while the volatility of the firm value is 10%. Using the Merton Model, calculate the value of the firms equity.
31
Solution
Formula is: St = V x N(d) Fe-r(T-t) x N (d-T-t) d = [1/ T-t] [ln (V t /D) + (r+ 2) (T-t)]
V
F
=
= =
value of firm
face value of zero coupon debt firm value volatility
interest rate
32
Solution
S d
= = =
= = =
60 N (2.005) (50) (.8607) N (2.005 - .17321) 60 N (2.005) (43.035) N (1.8318) (60) (.9775) (43.035) (.9665)
$17.057 million
33
Problem
In the earlier problem, calculate the value of the firms debt.
34
Solution
Dt = = = Fe-r(T-t) pt 50e-.05(3) pt 43.035 pt
Dt
43.035 - .092
= $42.943 million
Alternatively, value of debt = = Firm value Equity value $42.943 million = 60 17.057
35
36
KMV Model
Default tends to occur when the market value of the firms assets drops below a critical point that typically lies Below the book value of all liabilities
37
KMV Model
The KMV model assumes that there are only two debt issues. The first matures before the chosen horizon and the other matures after that horizon. The distance to default can be calculated as:
lnV0 l nD (r v2 / 2)T v T
38
KMV Model
The distance to default is a proxy measure for the probability of default. As the distance to default decreases, the company becomes more likely to default. As the distance to default increases, the company becomes less likely to default.
The KMV model, unlike the Merton Model does not use a normal distribution.
Instead, it assumes a proprietary algorithm based on historical default rates.
39
KMV Model
Using the KMV model involves the following steps: Identification of the default point, D. Identification of the firm value V and volatility Identification of the number of standard deviation moves that would result in firm value falling below D. Use KMV database to identify proportion of firms with distance-to-default, who actually defaulted in a year. This is the expected default frequency. KMV takes D as the sum of the face value of the all short term liabilities (maturity < 1 year) and 50% of the face value of longer term liabilities.
40
Problem
Consider the following figures for a company. What is the probability of default? Book value of all liabilities : $2.4 billion
: $1.9 billion
: $11.3 billion : $13.8 billion
: 20%
41
Solution
Distance to default (in terms of value) Standard deviation = 13.8 1.9 = $11.9 billion
42
Problem
Given the following figures, compute the distance to default: Book value of liabilities Estimated default point Market value of equity Market value of firm Volatility of firm value : : : : : $5.95 billion $4.15 billion $ 12.4 billion $18.4 billion 24%
43
Solution
Distance to default (in terms of value) = 18.4 4.15 = $14.25 billion Standard deviation = (.24) (18.4) = $4.416 billion 3.23
44