BITS Pilani presentation

BITS Pilani Shekhar Rajagopalan

Pilani Campus

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 BITS Pilani
Pilani Campus

FIN ZG514 Derivatives & Risk Management

Credit Risk
Chapter 24
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Introduction

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Objectives
Estimate the default probabilities using
• Historical data
• Credit spreads
• Merton’s model

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Credit Risk
FIs like banks, need to assess the credit risk of their loan and bond portfolios

The risk that an entity will fail to make a payment that it has promised

Government bonds are usually considered to be default-free

Corporate Bonds may default during the term of the contract

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When a Corporate Bond Defaults
The contracted payment stream may be:
• Rescheduled
• Cancelled by the payment of an amount which is less than the contracted value
• Continued but at a reduced rate
• Totally wiped out.

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Credit Event or Default Event
A credit event is an event that will trigger the default of a bond:
• Failure to pay either capital or a coupon
• Loss event (Corporate says that it is not going to make a payment)
• Bankruptcy
• Rating downgrade of the bond by a rating agency such as Moody’s

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Recovery Rate δ

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Recovery Rate δ
The fraction of the defaulted amount that can be recovered through bankruptcy
proceedings or some other form of settlement in the event of a default

Recovery rate is the extent to which principal and accrued interest on defaulted debt

can be recovered, expressed as a percentage of face value. 

The ‘loss given default’ (LGD) = 1 – δ

It is assumed that, if the corporate entity defaults, all bond payments will be
reduced by a known, deterministic factor 1 – δ, where δ is the recovery rate.

A constant δ = 40% is typically used in standard CDS and CDO models

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Recovery Rates

Moody’s 1982 – 2012

Class Mean (%)
Senior Secured 51.6
Senior Unsecured 37
Senior Subordinated 30.9
Subordinated 31.5
Junior Subordinated 24.7

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Example 1
Suppose δ = 0.9. In case the company defaults, what percentage of the bond value
will be received by the bondholders?

• Bondholders will receive 90% (the recovery rate) of the full amounts

• Once the company has gone into default, all future interest payments and the
redemption payment will be reduced by 10% since 1 – δ = 0.1

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Historical Default Rate

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Moody’s Avg Cum Default Rates (%) 1970 – 2012
Term (years) 1 2 3 4 5 7 10
Aaa 0 0.013 0.013 0.037 0.106 0.247 0.503
Aa 0.022 0.069 0.139 0.256 0.383 0.621 0.922
A 0.063 0.203 0.414 0.625 0.87 1.441 2.48
Baa 0.177 0.495 0.894 1.369 1.877 2.927 4.74
Ba 1.112 3.083 5.424 7.934 10.189 14.117 19.708
B 4.051 9.608 15.216 20.134 24.613 32.747 41.947
Caa-C 16.448 27.867 36.908 44.128 50.366 58.302 69.483
Consider a bond rated Aa
Probability that it will default by the end of the 1st year is 0.022%
Probability that it will default by the end of the 2nd year is 0.069%
Probability that it will default in the 3rd year is 0.139% - 0.069% = 0.07%

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Example 2
Term (years) 1 2 3 4 5 7 10
Aaa 0 0.013 0.013 0.037 0.106 0.247 0.503
Aa 0.022 0.069 0.139 0.256 0.383 0.621 0.922
A 0.063 0.203 0.414 0.625 0.87 1.441 2.48
Baa 0.177 0.495 0.894 1.369 1.877 2.927 4.74
Ba 1.112 3.083 5.424 7.934 10.189 14.117 19.708
B 4.051 9.608 15.216 20.134 24.613 32.747 41.947
Caa-C 16.448 27.867 36.908 44.128 50.366 58.302 69.483
Consider a bond rated Caa or below.
Compute P(Default during 3rd year given No earlier default)

P(Default during 3rd year) = 36.908 – 27.867 = 9.041%

P(No Default till end of 2nd year) = 100 – 27.867 = 72.133%
P(Default during 3rd year given No earlier default) = 9.041 / 72.133 = 12.53%

Suppose the time period is shorter – say Δt?

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Modelling Default Rate:
Intensity Based Model

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Example 3
λ = 0.75 / year
No Default: N Default: D

A. Find the probability that the country will not default within 1 year
B. Find the probability that the country will not default by time 2
C. Find the probability that the country will default by time 2
 This is a Poisson Distribution
X ~ Π(0.75 / year) &
A. P(X = 0) = e-λ = e-0.75 = 0.4724
B. P(X = 0 by time 2) =
C. P(X = 1 by time 2) =

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Hazard Rate or Default Intensity – λ(t)
λ(t)
No Default: N Default: D

 The hazard rate refers to the rate of death for an item of a given age (t)
λ(t): Hazard Rate or Default Intensity
The intensity process determines how likely default is over any given interval
X(t): State of the Company at time t
Q(t): Probability that the company will default by time t
X(t) = N Company has not defaulted from time 0 to time t
X(t) = D Company has defaulted during [0, t]

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Constant Default Intensity λ
λ
No Default: N Default: D
 

P(X(t) = N) = e-λt

Q(t) = P(X(t) = D) = 1 - e-λt

The higher the λ the higher the probability of default

As t Probability of default 1

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Default Intensity λ(t)
λ(t)
No Default: N Default: D

 l(t)Dt is the conditional default probability for a short period between t and t+Dt
• P(X(t+dt) = D | X(t) = N) = λ(t)dt
• P(X(t+dt) = N | X(t) = N) = 1 – λ(t)dt
Probability that the company will default by time t
•
where is the average hazard rate between time 0 and time t

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Example 4
λ(t) = 0.75
No Default: N Default: D

Find the probability that the country will default by time 2

 Q(t): Probability that the country will default by time t

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Example 5
Company X has just issued some 5-year ZCBs. The default intensity is given by λ(t)
= 0.002t , where t is the time in years since the issue of the bonds. Calculate the
probability that the company will have failed by the end of 5 years.

 Q(t): Probability that the country will default by time t

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Hazard Rates from Credit Spreads
 
Suppose
• s(T) is the credit spread of an asset with maturity T
• δ is the recovery rate

Average hazard rate between time zero and time T is approximately

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Example 5
Suppose
• The risk-free rate is 5% pa continuously compounded for all maturities
• Firm A has issued 1-year, 2-year and 3-year bonds with yields 6.5%, 6.8% and
6.95% respectively (also continuously compounded)
• Recovery rate is estimated to be 40%
Compute the average hazard rate for the 3rd year.
 s(1) = 150 bps, s(2) = 180 bps, s(3) = 195 bps

The average hazard rate for the second year: 2*3% - 1*2.5% = 3.5%
The average hazard rate for the 3rd year: 3*3.25%-2*3% = 3.75%

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Modelling Default Rate:
Structural Model

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The Merton’s Model
• Aims to link default events explicitly to the fortunes of the issuing corporate entity
• Focuses on the financial structure, debt equity ratio of the corporate entity
• Applies to a corporate entity issuing both equity and debt
• The total value of the company is V(t)
• Part of the company’s value is a ZCB with a face value of D at a future time T
• At time T the remainder of the value of the company will be distributed to the shareholders and
the company will be wound up
• The company does not pay dividend on its equity

• V(t) varies over time as a result of actions by the company

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Equity as a Call Option
 If V(T) < D
• The company will default
• The bondholders will receive V(T) instead of D and the shareholders will receive 0
The payoff to shareholders: Max [V(T) - D, 0] at time T
• The shareholders have a European call option on the company assets with maturity T
and K = D

The Merton model can be used to estimate

• The value of the equity today:
• The value of the debt today:
• The risk-neutral probability of default:
(Recall is the probability that the call will be exercised)
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Bondholders have a Put Option
Note that bondholders have first call on the company’s assets at maturity

If V(T) < D
• The company will default
• The bondholders will receive V(T) instead of D and the shareholders will receive 0
• The bondholders will receive D if V(T) ≥ D or V(T) if V(T) < D
• That is, Min [V(T), D] = D – Max [D - V(T), 0]

The debtholders’ claim is equivalent to a portfolio

• Long a default-risk-free bond paying D at time T
• Short a put option on the firm’s assets with a strike D and maturity T

The Merton model can be used to estimate

• The probability that the company will default and
• The market value of the debt

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The Merton Model Parameters
V0 : Market Value of company’s assets today
VT : Market Value of company’s assets at time T
E0 : Market Value of company’s equity today within the B/S/M framework
ET : Market Value of company’s equity at time T within the B/S/M framework
D: Debt repayment due at time T
σ : Volatility of the asset value (assumed constant)

Assumptions
1. Vt is observable (?!)
2. And therefore σ can be estimated
Using the Black-Scholes-Merton formula and the preceding discussion, we can value
the market value of the equity, the market value of the debt and the probability of
default.
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The Merton Model
 

where &

• Market Value of debt today: V0 - E0

• PV(Debt):
• P(Default): PD = 1 – N(d2) = N(-d2)
• Expected Loss:
• Expected Loss: Probability (Default) * (1 – Recovery Rate)
• Recovery Rate: 1 – EL / PD

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Example 6
To fund an expansion, ABC Inc has just issued 5-year zero-coupon bonds with a total face value of $10
million for 7.7880, taking its total asset value up to $15 million.
Assume the risk free rate is 5%pa (cont. comp.) and the annualised volatility of the company’s assets
over the 5-year period is 25%.
1. From the view point of the shareholders, calculate the value of the debt today
2. Calculate the probability that ABC will default.

V
  0 = 15, D = 10, σV = 25%, r = 5%, T = 5 year
d1 = 1.4520 , d2 = 0.8930
c = 15 * N(0.8930) – PV(D) * N(1.4520) = 15 * 0.9268 – 7.7880 * 0.8141 = 7.5613

• The market value of the equity (under B/S/M framework) today is 7.5613 million
• The market value of the debt today = V0 - E0 = 15 – 7.5613 = £7.4387 million

The probability of default = N(−d2) = = 1 − N(d2) =18.59%

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Example 7
To fund an expansion, ABC Inc has just issued 5-year zero-coupon bonds with a total face value of $10
million for 7.7880, taking its total asset value up to $15 million.
The price of a 5-year government ZCB is $77.88. Assume the annualised volatility of the ABC’s assets
over the 5-year period is 25% pa.
1. From the view point of the bondholders, calculate the value of the debt today
2. Calculate the probability that ABC will default.
Assume all rates are continuously compounded.

100e
  -5r
= 77.88 r = 0.050 or 5%
V0 = 15, D = 10, σV = 25%, r = 5%, T = 5 year

d1 = 1.4520 , d2 = 0.8930
p = 10e-0.05*5 * N(-0.8930) – 15 * N(-1.4520) = 7.7880 * 0.1859 - 15 * 0.0732 = 0.3493

The value of the debt today = PV(D) – p = 7.7880 – 0.3493 = £7.4387 million

The probability of default = N(−d2) = 1 − N(d2) or 18.59%

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Example 8
Given
V0 = 12.4, σ = 21.23%, D: $10 million, T: 1 year, r: 5% pa (cont. comp.), σ V : 21.23%
Assuming Merton’s model is applicable, compute the risk-neutral probability of
default

V0 = 12.4, D = 10, σV = 21.23%, r = 5%, T = 1 year

The probability of default = N(−d2) or 12.7%

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